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United States Securities and Exchange Commission
Proposed Rule:
Comments of Professor Thomas D. Morgan
Identification and Experience I write as a teacher of professional responsibility at The George Washington University Law School. I am co-author of a widely-used casebook in that field, and I served as an Associate Reporter to both the American Law Institute's Restatement Third, The Law Governing Lawyers and the American Bar Association's Ethics 2000 project. My comments, dated December 17, 2002, in File No. 33-8150.wp, provide more detail on my background and consulting activities. General Principles and Overview In my view, the Rule issued in Release No. 33-8185 on January 29, 2003 [hereafter the Final Rule] represents an outstanding job of complying with the statutory mandate of Section 307 of the Sarbanes-Oxley Act and of responding to concerns raised before the Commission. Indeed, as I have said in a number of settings, I believe the process leading to the Final Rule represented notice and comment rule making at its very best. In particular, the Commssion has limited the concept of "appearing and practicing before the Commission" to persons acting as attorneys for issuers in roles clearly involving securities law advice about material intended to be submitted to the Commission. Second, the definition of "evidence of a material violation" implicitly acknowledges that reasonable people can disagree about what a reasonable attorney would do in a given situation. The requirement of action only where it would be "unreasonable * * * not to conclude" that a risk of a material violation is "reasonably likely" has been criticized by some for its use of a double negative. Lawyers can always criticize drafting, but the point the test articulates is subtle and important. The Commission's test of "unreasonable * * * not to conclude" makes clear that not every theoretically "reasonable" idea must be reported. Third, the Commission has agreed to take a second look at the issue of noisy withdrawal. I will suggest doubts about the Proposed Rule, but I applaud the decision to consider the questions the proposal raises with the care and sensitivity they deserve. Specific Comments I know the Commission will receive many comments on the Final and Proposed Rules. Rather than try to cover many smaller points that are sure to be covered by others, I will suggest four significant ways in which I believe the Final and Proposed Rules can be improved.
* * * * * 1. The requirement of formal reporting under the Final Rule should be limited to matters "relating to the attorney's representation of the issuer." Requiring lawyers to report matters outside their scope of knowledge and expertise is likely to introduce distracting "noise" into the important process of monitoring corporate conduct. One way in which the Final Rule departs from the requirements of Rule 1.13(b) of the ABA Model Rules of Professional Conduct is that Rule 1.13(b) only requires internal reporting about a "matter relating to the representation." Reading § 205.3(b) of the Final Rule in light of the definition of "appearing and practicing" in § 205.2(a) seems to extend the lawyer's duty to matters about which the lawyer learns that do not relate to the lawyer's own work or area of expertise. Comments by Commission staff and others in educational programs since the Final Rule was issued suggest that the distinction was intentional. Clearly, no one can predict who will first become aware of corporate misconduct. It may seem hypertechnical to excuse an attorney with possibly valuable information about the clientfrom the duty to make that information available to the client. I acknowledge as well that some may believe that § 307 of the Sarbanes-Oxley Act requires the broad Final Rule standard. I respectfully suggest, however, that such views of the appropriate standard for requiring even up-the-ladder internal reporting assume that the costs of such reporting are low and that the more formal reporting that occurs, the better. I believe that assumption is seriously flawed. In fact, formal investigations contemplated by the Final Rule are likely to involve significant costs. Indeed, the risk of excessive, self-protective attorney reporting may legitimately be of equal or greater concern than the risk of insufficient disclosure. A formal investigation as contemplated by the Final Rule is, at the very least, likely to involve an issuer's soliciting an outside opinion or investigation that will often be expensive. More important, the need for the investigators' detailed access to company records, their need to interview employees who may themselves feel they must hire counsel, and the risk of otherwise creating excessively adversarial relations with corporate officials are all costs that should be taken seriously in determining the desirable frequency of such investigations. Clearly, investigation is essential where the risk of wrongdoing is real and the facts or law are unclear. My point is simply that formal reporting should not be seen as inherently desirable; the goal should be optimal - not maximum - reporting. Surely, it is obvious that the risk of uninformed reports - ones I describe as introducing distracting "noise" into the system - will increase significantly when attorneys report matters outside the field of their practice or experience. Imagine, for example, that Attorney provides tax advice to the issuer. She prepares tax opinions that she knows and advises should be filed with the Commission in connection with a required disclosure obligation. She, in short, "appears and practices before the Commission" and she does her tax work honestly and well. Now suppose Attorney hears from a friend in the company that the company's newly issued patent is subject to challenge based on prior art in the field that was not disclosed to the Patent Office. That information, if true, would be material to investors because both corporate officers and financial analysts have based predictions of the company's future success on the strength of that patent. If the friend had told Attorney about facts relating to a possible tax position, Attorney could relatively easily make the § 205.2(e) evaluation about whether the information was "credible" and whether a similarly situated reasonable lawyer would "conclude that it is reasonably likely that a material violation has occurred, is ongoing, or is about to occur." But how will Attorney make that judgment about an issue of patent law she does not understand? In particular, how can she do so when the issue ultimately requires a judgment about prior scientific literature that Attorney would likely be unable even to comprehend even if she were to read it? The likely answer is that, as a matter of self-protection, Attorney will simply make aformal report and shift the problem to the CLO as long as the Final Rule continues to require reports that do not relate to the attorney's representation of the issuer. If one thought that such reports were costless, that would be fine. As discussed above, however, reports will often involve real costs to the issuer and to the attorney-client relationship with that issuer. The problem described here only gets worse as the process required by the Final Rule continues. When the CLO gets back to Attorney with a response that the charge is baseless, Attorney will have little more basis upon which to evaluate the "adequacy" of that answer. She may know that a new lawyer has concluded that all is well, but her own evaluation of the "adequacy" of the conclusion will add little or nothing to its reliability. Or, suppose the time were to come for "noisy withdrawal." Presumably, under the Proposed Rule, Attorney would have to resign. What message would withdrawal by a tax lawyer send to the Commission and to investors? I suggest that it would be a message about non-existent tax problems rather than problems with the important patent. I recognize that it is hard to prove a point with a single hypothetical, but I also submit that making implications of rules concrete is helpful in understanding whether the rules will work effectively. The above example makes the more general point that an attorney who is required to report on a subject other than that on which she has worked for the company will almost certainly not be able to play the role the Commission hopes reporting attorneys will play throughout the process established by § 205.3 of the Final Rule. The conclusion seems to me plain. While an attorney should be able and encouraged to take any potential issue informally to the CLO, § 205.3(b)(1) should be amended to make clear that the formal § 205.3 process is only triggered as to a "matter related to the [attorney's] representation of the issuer." The Commission has already given substantive content to the general phrase "evidence of a material violation" in § 307 of the Sarbanes-Oxley Act, and my proposed amendment should be seen simply as a further step in that process. 2. The Final Rule should acknowledge that an attorney might determine quite early that invocation of a formal "reporting up" process is unnecessary. Specifically, an attorney who "reasonably believes" that no "material violation * * * has occurred, is ongoing or is about to occur" should not be required to initiate formal reporting even if there is "credible evidence" that is inconsistent with the attorney's reasonable belief. The Final Rule contemplates a multi-step process that § 205.3(b)(1) requires an attorney to begin when he or she has "evidence of a material violation." Apart from the case of referral to a QLCC, the obligation only ends when the attorney "reasonably believes" under § 205.3(b)(8) that the CLO has provided an "appropriate and timely response" to the initial report. To be "appropriate," the response must show that "no material violation * * * has occurred, is ongoing, or is about to occur" or that "appropriate remedial measures" have been put in place to correct such a violation [§ 205.2(b)]. The Final Rule seems to contemplate a lesser level of certainty to require the initial report than to support the ultimate conclusion. In panels on which I have participated, suggestions have been heard that there may need only be a 1-in-5 likelihood of wrongdoing to trigger the initial report, for example, but that reaching the conclusion that the response is "appropriate" requires the lawyer to find the lack of a violation "more probable than not." Whatever the statistical formulation of the respective issues, however, the idea remains that under § 205.3(b)(1) a formal report and a subsequent CLO or QLCC investigation may be required even when the attorney with "credible evidence" of a possible violation already "reasonably believes" that it is "more probable than not" that no "material violation has occurred, is ongoing, or is about to occur." With all respect, that makes no sense. It requires a continuing investigation even where the reporting attorney already has an objectively "reasonable belief" that "more probably than not" all is well. Take my hypothetical of Attorney, the tax lawyer who has concerns about the validity of a company patent. Imagine that Attorney takes her concern to the Assistant General Counsel (Patents) who says that he already knows of that concern and has had it investigated by a well-known outside patent firm. Attorney reads that outside report, including its detailed discussion of the prior art, and while she still may not understand the science, she concludes her original informant was simply wrong. Surely, that should be the end of the matter. No additional formal process should be required even if one could "credibly" say the first outside law firm could be wrong, or even that 1 law firm in 5 might reach a somewhat different conclusion. I believe the Final Rule can already be read to permit what I have proposed. Removal of the detailed documentation requirements from the originally-proposed Rule seems to recognize that not every concern need be addressed within a highly-structured process. Indeed, the term "report" in § 205.2(n) expressly includes "in person" reporting. Further, while the Final Rule appears to make the CLO the only acceptable recipient of information, surely the Rule should be understood to permit direct communication with the person in the CLO's office most likely to know the relevant facts and law. However, while the Final Rule could be read as I have proposed, that is not the reading I believe most attorneys - and perhaps Commission staff - will give it. I respectfully suggest that the Commission endorse the kind of informal investigation suggested in this Comment and make clear in § 205.3(b)(1) itself, or perhaps in the § 205.2(e) definition of "evidence of a material violation," that the duty to make a formal report to the CLO does not apply when an attorney already has a "reasonable belief" that no "material violation * * * has occurred, is ongoing or is about to occur." The attorney will then bear the risk of being wrong about that belief and later being accused of a failure to report. That risk should be enough to assure that attorneys will not abuse this principle. 3. The Final Rule should acknowledge the right of an attorney subject to the Rule to seek counsel within or outside the attorney's law firm about the attorney's obligationsunder the Final Rule without the person so consulted becoming subject to reporting obligations under that Rule. In general discussions about compliance with the Final Rule, it has become clear that many law firms plan to create a committee or identify particular partners to give advice to others in the firm about their obligations under the Final Rule. Some such individuals might be retained to give advice to attorneys in other firms as well. In some cases, the attorneys so consulted will appropriately be considered "supervisory attorneys" because they are regularly "supervising or directing" the attorney who raises the initial question. By the terms of § 205.4 and § 205.5, such supervisory attorneys will often be deemed to assume responsibilities of subordinate attorneys to make the report required by the Final Rule. My concern, however, relates to attorneys who do not fit the category of "supervisor." Such attorneys instead fill roles denominated "ethics advisor" or sometimes "general counsel" to a law firm. They typically know little about the substance of securities law or the activities of particular firm clients. What they provide is a fund of historical information and a reputation for good judgment within the firm about what the law governing lawyers requires lawyers to do. In this comment, I urge that such "advisors" should not be deemed "supervisory" within the meaning of § 205.4 of the Final Rule. The advisors should not themselves be deemed to have duties to report information to the issuer. More important, consultation with such an advisor should not satisfy a low-level attorney's obligation to so report either to the issuer or to a supervisor who is genuinely in a position to provide the report that the Final Rule requires. I believe the Final Rule already can be read to make the point that I am asking be further clarified. The definition of "appearing and practicing" in § 205.2(a)(2)(i) requires that the lawyer be "providing legal services to an issuer." The category of lawyers to which I refer typically has no such relationship with the issuer except as a member of a firm that has the issuer as a client. In considering both the Restatement Third, The Law Governing Lawyers, and new ABA Model Rule 1.6(b)(2), Professor Geoffrey Hazard often made the point that "sometimes even lawyers need lawyers." That is the point that underlies this comment. I respectfully suggest that the ability to consult such an ethics advisor without thereby creating yet someone else subject to reporting duties would violate no legitimate policy of the Sarbanes-Oxley Act and, indeed, would be likely to result in even greater compliance with the requirements of the Final Rule. 4. Noisy withdrawal should not be required by the Commission. The requirement confuses two ideas - the duty not to assist a client's crime or fraud and the possible duty to warn a third party of the client's conduct. Noisy withdrawal, as presently found in the ABA Model Rules of Professional Conduct, is a poor way to deal with those issues. Without doubt, the Commission will receive many comments about the Proposed Rule andthe possible requirement of noisy withdrawal. In the interest of not piling on, I will not develop here the arguments that:
I believe that each of the above arguments is important and, standing alone, may make clear that the noisy withdrawal requirement is undesirable. However, I leave development of those points to other comments, including my own in File No. 33-8150.wp, dated December 17, 2002. Instead, I offer different insights that I hope may help in the Commission's consideration of the Proposed Rule and its Alternative. In so doing, I recognize that the requirement of noisy withdrawal may seem consistent with the clearly desirable objective of conforming Commission rules to those already required by most states. I applaud the Commission's sensitivity to that objective and its respect for the concerns lawyers legitimately have about minimizing inconsistent attorney standards. The problem is that "noisy withdrawal" found its way into the ABA Model Rules as a result of a distinctly second-best political compromise. The principle conflates two different ideas. One is the duty under Model Rule 1.16(a)(1) to withdraw in circumstances where a failure to do so would cause the lawyer to "assist a client in conduct that the lawyer knows is criminal or fraudulent" in violation of Model Rule 1.2(d). The other is the possible duty of a lawyer to warn a third-party of a criminal or fraudulent act of the lawyer's client under Model Rule 4.2(b): "In the course of representing a client, a lawyer shall not knowingly * * * fail to disclose a material fact when disclosure is necessary to avoid assisting a criminal or fraudulent act by a client, unless disclosure is prohibited by Rule 1.6." Unfortunately, Model Rule 1.6 now prohibits such disclosure. When the ABA Model Rules were first considered in the early 1980s, Rule 1.6(b)(2) would have let lawyers reveal otherwise confidential information "to rectify the consequences of a client's criminal or fraudulent act in the furtherance of which the lawyer's services had been used." That proposal was defeated, primarily out of concern by litigators - not transactional lawyers - that it would reduce protection of their communications with clients. The same dynamic was repeated in 2002 in defeating a similar proposal to authorize lawyers to warn of a client's financial fraud. Noisy withdrawal was introduced late in the ABA's 1980's process when it was placed into the Comments to Model Rule 1.6. Those Comments did not receive the same attention from the ABA House of Delegates that the Rules themselves received, and thus noisy withdrawal slipped by as a backhanded way for a lawyer to "signal" something is wrong while not explaining what the signal means. Noisy withdrawal, in short, is the professional equivalent of "charades," the parlor game in which participants seek to read substantive content into otherwise ambiguous gestures. The problems of restoring investor confidence - and the role of good legal advice in that process - are too serious to be transformed into such a game. Withdrawal - and release of information about the reasons for that withdrawal - raise quite different issues, and I address them separately. First, a lawyer's withdrawal is costly for any client. Clients may fire their lawyers, of course, but when a lawyer walks away in the middle of a representation, it is the client who gets hurt. Thus, lawyer professional rules - e.g., ABA Model Rule 1.16 - properly place significant limits on a lawyer's right to withdraw without client consent. As discussed above, lawyer withdrawal is already required by Model Rule 1.16(a)(1) when a failure to withdraw would involve the lawyer in knowingly assisting a client's crime or fraud. In adopting a rule going that far, the Commission would be building upon an established principle. I thus encourage adoption of the triggering standard now proposed for § 205.3(d)(1) - the "attorney reasonably believes that a material violation is ongoing or is about to occur and is likely to result in substantial injury to the financial interest or property of the issuer or of investors." That is a step beyond the "knowing" standard in the Model Rules, but it requires that the attorney in fact believe the facts to be true and requires that the belief be reasonable. That comes quite close to the view of "knowing" likely to be proposed by the ABA's Task Force on Corporate Responsibility for Model Rule 1.13(b), and it seems a fair articulation of the kind of circumstance that should require attorney withdrawal. However, such a withdrawal standard requires an important qualification. In my earlier hypothetical, Attorney, the tax lawyer, would have no right or obligation under Model Rule 1.16 to stop giving tax advice because she thought the client might have a doubtful right to a patent. Surely, that is the right result. At least, the Commission should make clear that any requirement of attorney withdrawal in the Proposed Rule should be limited to withdrawal from the specific representation that involves a "material violation" as defined in § 205.2(i). The Proposed Ruleshould not require that the attorney sever all ties with the allegedly offending client. Finally, in the Alternative Proposal, the Commission has introduced a § 205.3(d)(2) that excuses the attorney from withdrawal if the attorney may not withdraw without permission of a tribunal and the tribunal has refused to grant that permission. That situation is not likely to arise often in the case of a transactional lawyer, but it is an important principle that I believe should be retained in any rule that is issued. Second, then, I turn to the harder question of disclosure of the fact of - or reasons for -the withdrawal. I begin with the observation that disclosure of information to securities markets is not an unvarnished good. Accurate, easily-understood information makes markets work better. Confusing, ambiguous information can make markets work less well, however, if investors are led to believe they know facts but later find they are untrue or less significant than they appeared. Charades may be funny in the family room, but securities markets process clear information best. In § 205.3(c)(2) of the Final Rule, the Commission has already adopted a provision for explicit permissive disclosure of the problem creating a perceived "material violation." The attorney may "reveal to the Commission, without the issuer's consent, confidential information related to the representation to the extent the attorney reasonably believes necessary" to prevent or rectify a "material violation" causing "substantial injury to the financial interest or property of the issuer or investors." In short, the Commission already has approved a method of disclosure that can provide the kind of accurate, helpful information that "noisy withdrawal" never will. To be sure, under the Final Rule, disclosure is permissive rather than mandatory. I have heard it said that permissive disclosure would result in too little disclosure to the Commission, but I believe that view is mistaken. Mandatory versus permissive disclosure was extensively examined in preparation of Restatement Third, The Law Governing Lawyers § 67, which found permissive disclosure to be the prevailing rule and the right result. Comment k explained that any such disclosure "would inevitably conflict to a significant degree with the lawyer's customary role of protecting client interests. Critical facts may be unclear, emotions may be high, and little time may be available in which the lawyer must decide on an appropriate course of action." Making disclosure mandatory in such circumstances "would be unwarranted." Further, lawyers will have significant incentives to make permissive reports where they are justified in doing so. A lawyer would need several lifetimes to overcome the damage to his or her reputation caused by failing to disclose something that later causes serious public harm. Thoughtful professionals will not let clients put them in that position. But if the Commission were to adopt mandatory disclosure of an attorney's withdrawal, it should be in the form of the Alternative Proposal in which disclosure to the Commission is made by the issuer. First, although many disclosure statements are written by attorneys, disclosure obligations are the issuer's and the Alternative Proposal simply acknowledges that fact. Second, issuer disclosure creates fewer conflicts with court-imposed rules against attorney disclosure. Make no mistake, however, pressures on the attorney-client relationship will be equally great no matter who is required to disclose. The further possibility that information about lawyer withdrawal will create more market "noise" than understanding makes the proposed requirement that the issuer immediately issue a Form 8-K a more precipitous step than necessary. Thus, I would suggest adopting the proposal on which the Commission has asked for comment whereby the issuer could fail to inform the Commission of the withdrawal where a committee of independent directors, acting upon the advice of counsel not involved in the underlying facts, determines that the withdrawing attorney acted unreasonably in doing so. Further, I would favor the possibility that I understand others may be proposing whereby an issuer could describe to the Commission the controversy leading to the attorney's withdrawal in a confidential manner that would go to the securities markets only if the Commission believed it would be appropriate to release it. Honest reporting is critically important; misinformation is a real problem. Care dealing with information the issuer is compelled to disclose seems essential. Summary and Conclusions As indicated at the outset of these comments, I believe the Commission has done an exceptional job of accommodating the Final Rule to the concerns expressed earlier. The changes suggested here similarly seek to minimize attorney complicity in corporate wrongdoing and optimize attorney efforts to prevent such wrongdoing. First, while informal internal reporting should always be proper, formal reporting should be only required in matters relating to the attorney's representation of the client. Such a rule would help assure that matters requiring investigation by the CLO come from people likely to have reliable information and a real understanding of the nature of the possible illegality. Similarly, cutting short the reporting-up process when the reporting attorney forms a "reasonable belief" that his or her earlier "evidence" of possible misconduct was inaccurate would focus investigations in directions that have a real chance of turning up illegal conduct. Giving attorneys authority to consult ethics advisors without making those advisors seen to be "appearing and practicing before the Commission" should help attorneys get sound counsel about their obligations under the Final Rule and how properly to satisfy them. Finally, current professional standards about when to require withdrawal are sufficient, and § 205.3(d)(2) of the Final Rule already provides authority to make factual disclosures needed to prevent or rectify a "material violation." I respectfully submit that with the changes proposed here, and perhaps others the Commission will receive, the Final Rule will satisfy the formal requirements of Sarbanes-Oxley § 307 and make attorneys both faithful representatives of clients and constructive participants in the effort to put honest, accurate information before investors. |