| The
SEC’s Rules Governing Lawyers:
Where to Go from Here?1
Testimony of George M. Cohen
Edward F. Howrey Research Professor
University of Virginia School of Law
Before the
Subcommittee
on Capital Markets, Insurance and Government Sponsored Enterprises
Committee on Financial Services
United States House of Representatives
February 4, 2004
Hearing
on The Role of Attorneys in Corporate Governance
 |
| Professor George Cohen |
1. Introduction
I have been asked to discuss the merits of the SEC’s adopted
and proposed Standards of Professional Conduct for Attorneys Appearing
and Practicing Before the Commission in the Representation of an Issuer.2 I
will begin by providing some background information about the regulation
of lawyers generally. I will then offer an assessment and critique
of several of the SEC rules’ more important provisions. I then
discuss the SEC’s noisy withdrawal proposal. Finally, I will
recommend further steps Congress and the SEC might take to improve
the effectiveness of corporate lawyer regulation.
I will state my conclusions up front. I strongly support section
307 of the Sarbanes-Oxley Act,3 and applaud the SEC’s
careful and detailed efforts to implement Congress’s directives.
I am, however, concerned that the SEC’s rules, as drafted, will
be difficult to enforce and may wind up having far less effect on corporate
lawyer behavior Congress might have hoped. Fixing the rules that the
SEC has already promulgated should be the biggest priority. I also
support the SEC’s noisy withdrawal proposal and urge this Committee
to encourage the SEC to adopt it.
I need not recount the sorry history of corporate wrongdoing we have
witnessed in the opening years of the twenty-first century. We are
still living with the consequences, unraveling the causes, and punishing
the perpetrators of Enron, Global Crossing, WorldCom, Tyco, Adelphia,
and other scandals. Not only that, new scandals continue to surface,
even on a global scale (witness Parmalat).
These scandals have raised serious questions about the integrity,
acuity, and prudence of lawyers who facilitate and document business
transactions and approve required financial disclosures. We have seen
strong evidence that lawyers in these scandals structured bogus deals,
vouched for nonexistent “sales,” and whitewashed reports
to keep regulators and potential plaintiffs at bay. Yet lawyers have
to date have largely escaped responsibility. And they have received
far less scrutiny for their role in recent corporate wrongdoing than
accountants, corporate managers, and boards of directors.
But in enacting the Sarbanes-Oxley Act of 2002, Congress included
section 307, a provision notable for its recognition of the important
role corporate lawyers play in ensuring compliance with the law, as
well as the need for federal oversight of this role to protect the
investing public. Section 307 directed the SEC to promulgate “minimum
standards of professional conduct for attorneys appearing and practicing
before the SEC in any way in the representation of a issuers.” Section
307 went even farther. It specified that one of those “minimum
standards” require lawyers to “report evidence of a material
violation of the securities laws or a breach of fiduciary duty or similar
violation by the company or any of its agents to the chief legal officer
or the chief executive officer of the company (or the equivalent thereof).” If
the chief legal officer or chief executive officer fails to provide
an “appropriate response” to the evidence, the lawyer would
be required to “report the evidence to the audit committee, another
independent committee, or the full board of directors.” Almost
a year ago, on January 29, 2003, the SEC adopted rules pursuant to
section 307, which became effective on August 5, 2003.
2. Lawyer Regulation: Form
To evaluate the importance and the impact of the SEC rules, it is
important to separate out two questions: who should regulate corporate
lawyers, and what should the content of those regulations be. I will
briefly address both.
Lawyers have long been regulated by state disciplinary authorities
run by state courts. The law that applies in disciplinary hearings
is the ethics code adopted by that particular state. Typically, the
ethics rules are based on the Model Rules of Professional Conduct or
the Model Code of Professional Responsibility, both promulgated by
the ABA. But it is important to recognize that the ABA’s version
of the ethics rules has no force of law by itself. The relevant state
authority must adopt these rules, and need not follow the ABA’s
version. That fact is particularly important for discussing corporate
fraud, because until recently, the ABA’s ethics rules on confidentiality
have diverged from the actual ethics rules adopted by most states.
Although state disciplinary authorities handle some types of lawyer
wrongdoing (particularly by sole practitioners and lawyers at small
firms) fairly well, they are not effective regulators of the lawyers
who do corporate transactional work at large firms for large, publicly
traded corporate clients. State disciplinary authorities lack the resources
and the expertise to successfully prosecute disciplinary actions against
these lawyers, who are sophisticated, well-financed, and ready to defend
their actions with a full and potent arsenal. As a result, we have
seen few, if any, disciplinary actions brought in connection with large
corporate scandals, either past or present. And that is true despite
strong evidence of lawyer wrongdoing in a number of cases.
The impotence of state disciplinary authorities to regulate large
firm corporate lawyers is an important, if underappreciated, fact,
though Congress did recognize this fact in passing section 307.4 One
of the major objections lawyers have made to federal regulation, including
section 307 and the SEC rules, is that lawyers are already regulated
by state ethics rules. If, however, state disciplinary authorities
cannot effectively reach corporate practice by lawyers in large firms,
these objections ring hollow. Thus, when these lawyers argue for state
disciplinary regulation, they are really arguing for no effective regulation
at all.
Regulation by federal agencies of lawyers who practice before those
agencies holds out at least some hope of effectively influencing large
firm corporate lawyers. These agencies have better resources and greater
expertise than state disciplinary authorities. Moreover, regulation
by federal agencies provides another advantage over state regulation:
uniformity. This advantage is particularly important when state rules
diverge, as the state disciplinary rules on confidentiality do. In
passing section 307, Congress recognized these advantages of regulating
lawyers through federal agencies. But it is important to note, again
because some lawyers seem to think otherwise, that securities lawyers
are not the only lawyers who have been subject to federal regulation.
Tax lawyers, patent lawyers, and others are also regulated by federal
agencies. On the other hand, it is also important to note the limitations
of regulation of lawyers by federal agencies.5 These agencies
often have numerous tasks they are required to perform besides regulating
lawyers, and they are always battling budgetary restraints and personnel
limitations. Moreover, in part because these agencies are staffed by
lawyers who hope one day to enter, or return to, private practice,
there is a good deal of sympathy for corporate lawyers.
A third form of lawyer regulation, and the one feared most by many
corporate lawyers, is liability. Lawyers are subject not only to disciplinary
rules, whether promulgated by states or federal agencies, but also
to laws of general applicability. Most notably, state tort laws concerning
fraud and federal laws establishing liability for securities fraud,
apply to lawyers. Liability for both forms of fraud can be either civil
(paying damages) or criminal (fines or prison sentences). Lawyers also
face the possibility of malpractice actions by their corporate clients
if they do not sufficiently protect their clients from misbehaving
managers, though in practice such suits are generally brought only
in bankruptcy proceedings by the trustee. Section 307 does not address
liability and the SEC rules specifically disclaim any attempt to create
new causes of action against lawyers. But the liability question always
lurks in the background of any debates over other forms of regulation
because even though in theory they are independent, lawyers always
fear that the content of disciplinary rules affects their liability.
In particular, one of the main justifications lawyers offer for strong
confidentiality rules is the belief that such rules will successfully
stave off liability. This belief often turns out to be a false hope,
but many lawyers seem to be misled nonetheless.
A significant change in the potential for liability to regulate corporate
lawyers occurred in 1994, when the Supreme Court, in the Central
Bank case,6 declared that private damage suits for
aiding and abetting could not be brought under the federal securities
laws. These suits had been important vehicles for “disciplining” lawyers
in past instances of corporate fraud, particularly the savings and
loan crisis. Congress had a chance to overturn Central Bank when
it passed the Private Securities Litigation Reform Act. But Congress
declined to do so, because the bigger concern at that time was with
perceived abuses by plaintiffs’ lawyers in bringing class action
suits for securities fraud than with deterring such fraud. Congress
did reaffirm the right of the SEC to bring aiding and abetting suits
against lawyers and other professionals, but it changed the “recklessness” standard
that had been used by many courts to an “actual knowledge” standard,
which is more difficult to prove.
3. Lawyer Regulation: Content
The debate over the content of the rules governing corporate lawyers,
whether disciplinary, regulatory, or general law, has focused on one
distinction and one tension. The distinction is between so-called “up-the-ladder
reporting” or “reporting up,” and so-called “reporting
out,” which involves questions of withdrawal and disclosure.
The tension is between the lawyer’s duty not to counsel or assist
a client in committing a crime or fraud and the lawyer’s duty
of confidentiality to the client. The distinction and the tension are
related: both reporting up rules and reporting out rules are designed
to flesh out how the lawyer is to navigate between the avoidance of
aiding and abetting and the protection of confidentiality.
a. Reporting Up
The SEC rules are directed primarily to reporting up, which was the
one thing section 307 required the SEC to address. The purpose of reporting
up is to implement the universally accepted “entity theory” of
corporate representation, under which the corporate lawyer is supposed
to represent the corporation as an entity rather than management when
managers are breaching their fiduciary obligations to the corporation
or leading the corporation to engage in wrongdoing. A lawyer who discovers
a manager’s misconduct, but continues to advise and assist the
manager without stopping and redressing the misconduct, risks being
deemed to have assisted in the misconduct. Of course, reporting up
is easier said than done, especially when the lawyer has a close working
relationship with management, and management generally has the authority
to direct the lawyer’s actions, as well as to fire the lawyer.
Thus, corporate lawyers have accepted the reporting up obligation
in principle, but grudgingly and often with numerous qualifications.
In particular, they have argued that managers will hesitate to consult
and confide in them if they fear that the lawyers might go over their
heads to the board. Although corporate lawyers owe no duty of confidentiality
to managers, this argument is the same argument lawyers make in favor
of strict confidentiality rules. Model Rule 1.13, as it existed up
until last summer, reflected these concerns by limiting the lawyer’s
obligations in several ways. In particular, Model Rule 1.13 does not
require a lawyer to do anything unless a lawyer “knows” that
a corporate agent is engaged in wrongdoing. Moreover, Model Rule 1.13
includes reporting up as merely one possible option in responding to
a rogue manager, rather than (at least under the interpretation given
the provision by many lawyers) making it mandatory. The idea was to
preserve maximum lawyer discretion.
The main substantive goal of section 307 and the SEC rules was to
make reporting up mandatory and to trigger the obligation by “evidence
of a material violation” rather than actual knowledge. Congress
determined, correctly in my view, that there was sufficient evidence
that too many lawyers were throwing in their lot with rogue managers
rather than protecting the interests of their corporate clients. How
well the SEC succeeded is a point I will address below.
b. Reporting Out
Reporting out has engendered much more discussion, and much more
controversy than reporting up. But the question involved is essentially
the same. If the corporation’s board turns out to be corrupt
and in cahoots with the rogue managers, can the lawyers continue to
advise and assist the corporate client without becoming complicit in
the wrongdoing? If not, what may or must the lawyer do to extricate
himself from the situation?
Traditionally, the ethics codes and the other law regulating lawyer
conduct have, for the most part, been consistent in their answers to
these questions. If continued representation of a client constitutes
illegal assistance, the lawyer must withdraw from the representation.
A lawyer is permitted to disclose confidential information to prevent
a client’s prospective crime or fraud. And when the client in
the course of the representation has used the lawyer’s services
to perpetrate a crime or fraud on a person or a tribunal, the lawyer
is required to disclose confidential information to the extent necessary
to rectify the consequences of the crime or fraud.
The reasons for these rules are straightforward. Neither the legal
profession nor society as a whole should tolerate a regime in which
lawyers may be used by clients as a means of carrying out a crime or
fraud. The possibility of disclosure reinforces the lawyer’s
duty to provide only lawful assistance and advice to clients,
and provides the lawyer with a last-resort weapon and increased leverage
in dealing with a difficult client or one embarked on an unlawful or
fraudulent course of conduct. Moreover, a lawyer’s failure to
take reasonable steps to prevent or rectify client fraud is likely
to lead to civil liability of the lawyer. If insolvency and litigation
occur as an aftermath of the fraud, a frequent occurrence, the client’s
confidentiality will inevitably disappear. A public company often desires
to cooperate with likely to waive any privileges in an effort to recover
assets for the insolvent entity; and, if these events do not take place,
the crime-fraud exception of the privilege may be successfully investigators
and waiving the privilege is often part of successful cooperation;
a successor in interest, such as a bankruptcy trustee, is invoked;
finally, if the lawyer is charged by defrauded persons, the lawyer
will use the self-defense exception to confidentiality.
Despite the traditional answers to the reporting out question and
the arguments in favor of these answers, the ABA in its ethics rules
abandoned mandatory disclosure of transactional fraud in 1974 and permissive
disclosure of such fraud in 1983. The source of the professional concerns
that led to the ABA’s retrenchment is relevant to today’s
concern that professional advisers have failed to perform their functions
of preventing corporate wrongdoing. The ABA’s actions in 1974
and 1983 were heavily influenced by the hostility of important segments
of the legal community to the SEC’s efforts during the 1970's
to apply the ethics rules on disclosure to securities lawyers who remained
silent when they knew or should have known that their client was engaged
in a course of conduct that violated federal securities laws. Those
propositions had not been viewed as problematic when they were not
enforced by state disciplinary authorities. But when SEC enforcement
came into play with the National Student Marketing case,7 the
two propositions were attacked and drastically narrowed by the ABA.
The states, however, for the most part did not go along, creating
a hodgepodge of rules on the subject of permissive and mandatory disclosure
of client fraud. The current landscape may be briefly summarized as
follows. Forty-one states permit (and four of those require) a lawyer
to disclose confidential information to prevent a client’s criminal
fraud. Forty-four states require (and three permit) a lawyer
to disclose confidential information relating to a client’s ongoing
criminal or fraudulent act. And eighteen states permit a lawyer to
disclose confidential information to rectify or mitigate a past client
fraud in which the lawyer’s services were used.
The SEC rules as they currently stand contain a permissive disclosure
provision, under which a lawyer may reveal to the SEC information that
the lawyer reasonably believes necessary to prevent the issuer from
committing a material violation or to rectify the consequences of a
material violation, though disclosure for rectification purposes requires
that the lawyer’s services have been used.
After the enactment of section 307 and the promulgation of the SEC
rules, the ABA last summer changed its confidentiality rule, Model
Rule 1.6, to permit disclosure of information either to prevent the
client from committing a crime or fraud or to rectify a past or ongoing
fraud in which the lawyer’s services were used. The ABA also
changed Model Rule 1.13 to include permissive disclosure outside the
organization, even if the lawyer’s services are not being used
to perpetrate wrongdoing by an organization, though the matter must
be related to the lawyer’s representation. The primary motivation
for these changes was to stave off further regulation by the SEC, and
in particular the noisy withdrawal requirement. It is important to
note that by permitting disclosure of ongoing fraud in Model Rule 1.6,
the ABA has effectively required disclosure in cases of ongoing fraud
in which the lawyer’s services have been used. Model Rule 4.1(b)
says that a lawyer “shall not knowingly fail to disclose a material
fact to a third person when disclosure is necessary to avoid assisting
a criminal or fraudulent act by a client, unless disclosure is prohibited
by rule 1.6.”
One other point about reporting out is worth mentioning because there
seems to be much misunderstanding about it. Sometimes press reports
contain statements to the effect that lawyer disclosure of client confidences
waives the client’s attorney-client privilege. In fact, although
some disclosures by lawyers may involve situations in which the crime-fraud
exception to the privilege may apply, lawyer disclosure by itself,
if not authorized by the client, does not generally waive the client’s
privilege, since the privilege belongs to the client.
4. Advocates versus Counselors
The SEC rules are largely addressed to lawyers acting in a counseling
rather than an adversarial role. Their purpose is to enhance compliance
with the law. Reporting evidence of misconduct and litigating are two
very different legal events, even though they may involve the same
conduct. Of course, the reporting of evidence of material violation
may lead to litigation over whether a violation has occurred, but it
need not.
The bar sometimes speaks as if every lawyer’s job is to behave
as lawyers in adversary adjudicatory proceedings are privileged to
behave. But that is not so: lawyers who facilitate transactions or
advise clients in private on complying with the law perform distinct
functions in our democracy and operate in radically different environments
from those inhabited by advocates engaged in adversary proceedings.
Advocates operate in an environment designed to guard against abuses
of that broad license to manipulate fact and law. First, there is an
adversary party equipped (in almost every case) with a lawyer both
armed with information sufficient to challenge vigorously every theory,
far-fetched or standard, that the opposing lawyer can make. Second,
there is a judge who is acting as legal umpire (and sometimes as a
neutral fact finder) and frequently a separate fact finder, the jury,
in addition to the judge – actors obligated to decide with objectivity
and neutrality between the contrasting visions of law and fact presented
by the battling lawyers. None of those checks is present when, in the
privacy of the office and the protections of lawyer confidentiality,
a legal advisor counsels a client or corporate manager that it can
act based on some unprecedented vision of what the law requires or
some barely plausible interpretation of facts. In short, advocates
have much more license to manipulate law and facts than advisors do.
And that is how it should be. Lawyers as advisors are a private sector
solution to intrusive government alternatives to ensure that corporations,
other entities and individuals operate within and not without the law.
It is simply not true that the advisor’s job is to stand by the
client’s position, no matter how implausible as a matter of fact
or law, and not judge the client, as lawyers often assert. Advocates
should not judge because there are others charged with that role in
the environment in which they operate and they are present to guarantee
the clash of positions that our adversary system depends upon. But
advisors are relied upon to give advice made on prudent judgments.
How else are they to tell anyone what the law requires and what it
does not? And that is the role for which they are retained and paid
to perform. The SEC rules do not change the traditional responsibility
and role of lawyer-advisors; they just insist that lawyers properly
fulfill that role and not act as advocates in situations where such
behavior is not permitted or appropriate.
5. Problems with the SEC Rules as They Now Stand
In our comments to the SEC and in a forthcoming paper, Roger Cramton,
Susan Koniak, and I offer a detailed critique of a number of the rules
the SEC has adopted. For purposes of this testimony, I will discuss
the three main problems we find with the SEC’s rules.
a. The Triggering Standard for the Lawyer’s Duty to Report
The heart of §307, and of the SEC rules, is the lawyer’s
duty to report. The key question under the duty to report is what circumstances
trigger that duty. Section 307 obligated the SEC to adopt a rule requiring
a lawyer “to report evidence of a material violation of securities
law or breach of fiduciary duty or similar violation by the company
or any agent thereof, to the chief legal counsel or the chief executive
officer of the company (or the equivalent thereof).” The rule
implementing this requirement, §205.3(b), states: “If an
attorney, appearing and practicing before the Commission in the representation
of an issuer, becomes aware of evidence of a material violation by
the issuer or by any officer, director, employee, or agent of the issuer,
the attorney shall report such evidence to the issuer’s chief
legal officer (of the equivalent thereof) or both the issuer’s
chief legal officer and its chief executive officer (or the equivalents
thereof) forthwith.” The SEC rules define “evidence of
a material violation” in §205.2(e) as “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 occurring, or is
about to occur.”
In assessing how faithfully and well the SEC rules implement the
Congressional mandate, it is important to keep in mind the goals of §307.
In the wake of Enron and other corporate scandals, Congress was concerned
that too many corporate lawyers were taking a “see no evil, report
no evil” approach to their representations. Any lawyer worth
his salt knows that assessing whether the law is actually being violated
is no simple task. One extra fact, one nuance, one affirmative defense,
one creative ambiguity, and a judgment of “illegality” is
transformed into something more benign. Unfortunately, as lawyer behavior
in the S & L scandal and countless other financial debacles demonstrates,
the inevitable “grayness” or uncertainty of all law – a
characteristic of all just legal regimes and not a flaw – has
become an excuse for ignoring evidence of illegality, no matter how
substantial the evidence or harm being wrought has been.
The purpose of §307 was to change this corporate legal culture
and practice and encourage more reporting of dubious corporate activities.
Thus, Congress abandoned the “subjective” approach of Model
Rule 1.13(b), which imposes no obligations on a lawyer unless she “knows” that
illegal activity is occurring or will occur. Instead, Congress mandated
an objective trigger, while at the same time lowering the triggering
standard from one of definitive violation to “evidence” of
a violation. The hope was that an objective, probabilistic “evidence” trigger
would be less subject to manipulation by lawyers inclined not to notice
evidence of wrongdoing or to explain such evidence away. The question,
then, is whether the SEC rules further this objective. The answer,
unfortunately, is no.
In deciding whether to act – whether to report what Congress
wanted to encourage lawyers to report up the corporate ladder – the
lawyer confronting the definition of “evidence of a material
violation” in §205.2(e) must ask herself whether it would
be unreasonable not to conclude that the evidence before her
demonstrates a reasonable likelihood of a material violation of law.
This definition, which triggers the “up-the-ladder” reporting
duty, is troublesome because its use of a double-negative formulation
makes the standard difficult to understand, interpret or apply. Law
is intended to guide action in the world. Yet it is barely possible
to read the SEC’s definition out loud without tripping (or, as
I have discovered when presenting this definition in various fora,
chuckling) over the words, let alone trying to remember the definition
without reading it or trying to work out its “logic.”
Moreover, the SEC’s standard fails another critical test of
sound rulemaking. It would be a nightmare to enforce. The Commission
has asked its staff to assume the burden of proving not just one negative,
but two. To enforce this rule, the Commission would have to show that
it was unreasonable for a lawyer not to conclude
that a violation was reasonably likely. I do not believe that this
burden is a realistic one to ask the staff to meet.
The SEC’s defense of this definition in the Adopting Release
is that it “recognizes that there is a range of conduct in which
an attorney may engage without being unreasonable.” The idea
is that if any “prudent and competent” lawyer might conclude
that the evidence did not support the conclusion that a material violation
has occurred, up-the-ladder reporting is not required. But this standard
renders the reporting requirement of §307 nearly an empty shell.
Any good lawyer will almost always be able to conclude that it is not ‘unreasonable’ to
conclude that the evidence before her demonstrates legal conduct. Lawyers
are trained to re-imagine evidence of illegality as evidence of legality.
Not only will lawyers be able to reach this conclusion, they have strong
motives to do so. The ethos of lawyers is not to report up the corporate
ladder, and to find any possible way to avoid doing so.
The SEC could easily have adopted a rule that a lawyer must report
when confronted with information that a prudent and competent lawyer,
acting reasonably under the circumstances, would conclude was credible
evidence of a material violation. In fact, that is precisely the triggering
standard that Roger Cramton, Susan Koniak, and I proposed in our comments
to the SEC, and which we still support. This clearer and more straightforward
definition, incorporating a standard conception of reasonableness,
would provide ample recognition of a “range of conduct” and
the need for lawyer discretion. It would also be consistent with Congress’s
intent by providing an objective standard (a “prudent and competent
lawyer, acting reasonably under the circumstances”) with respect
to both the factual question (“credible evidence”) and
the legal question (“material violation”). The fact that
the SEC opted for a more convoluted double-negative standard, rather
than the more straightforward standard, will be read by many lawyers
as an invitation to inaction. The bar needs no such invitation and
Congress surely did not intend the Commission to offer one.
The triggering standard is the gateway to the entire set of obligations
created by the rules. If that standard is so weak that lawyers inclined
to do so can easily circumvent it, if it is so ambiguous, convoluted,
and weak that the SEC cannot effectively enforce it, the rules will
not have effectuated the statutory objective. I find it disappointing,
then, that so little attention has been paid to the triggering standard
compared to other issues, most notably noisy withdrawal.
I find it even more disappointing that many lawyers who did pay attention
to the trigger, and the SEC which sympathized with their objections,
so strongly resisted a simple, objective standard, stated in affirmative
terms, which would fully implement Congressional intent that lawyers
report evidence of a material violation, while at the same time preserving
an appropriate degree of lawyer discretion. The resistance is all the
more troubling when one considers how little is really being demanded
of the lawyer at the initial stage. The lawyer must simply report “evidence
of a material violation” to the corporation’s chief legal
officer. The “report” is not a formal, detailed document,
but can be a simple phone call, e-mail, or even casual water cooler
comment. More important, the lawyer is not required to take any further
steps without an additional, more demanding trigger, being satisfied.
b. Colorable Defense as an Appropriate Response
Aside from the initial duty to report evidence of a material violation
to the chief legal officer or chief executive officer, the other key
component of §307 is the obligation of the reporting lawyer to
report the evidence up the corporate ladder to the board or relevant
board committee if the chief legal officer or chief executive officer
does not “appropriately respond” to the reporting lawyer.
The SEC implemented this directive in §205.3(b)(3), which states
that the reporting lawyer “shall report evidence of a material
violation” to the board or relevant board committee, unless the
lawyer “reasonably believes that the chief legal officer or chief
executive officer . . . has provided an appropriate response within
a reasonable time.”8
The effectiveness of the SEC’s rule implementing the reporting
up obligation thus depends crucially on the definition and meaning
of “appropriate response.” Section 205.2(b) defines “appropriate
response” to mean one of three things: there is no material violation;
there is a material violation but it is being addressed with “appropriate
remedial measures”; or another lawyer has been retained or directed
to investigate the matter further. One would expect that the third
option would simply default to one of the first two scenarios (no violation,
violation being remedied) once the investigating lawyer completes the
investigation. But the SEC rules offer a new possibility: the corporation
makes an “appropriate response” if the “investigatory
lawyer” advises the corporation that he or she “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.” Thus,
the rule as adopted suggests that one alternative to stopping an ongoing
fraud or abandoning plans to commit a new fraud is to get an opinion
from a lawyer that should the issuer be investigated for the illegal
conduct (there is no requirement in the definition that the investigation
be underway, pending, or even likely to occur), a colorable defense
would be available.
In my view, corporations will have a strong incentive to take advantage
of this “colorable defense” option when faced with a report
by a lawyer. And much like the confusing initial trigger, this option
threatens to undermine Congress’s intent in enacting §307.
The colorable defense standard will result in too little reporting
up of such evidence. The SEC should not be suggesting to anyone that
the fact that a lawyer can (in good faith and/or reasonably) state
that a “colorable” defense would be available, if the action
is ever challenged, licenses an issuer to engage in activity that may
more likely than not be illegal.
The problem with the colorable defense option is that it applies
a standard appropriate to litigation to the quite different context
of counseling and legal compliance, which is the primary concern of
section 307 and the SEC rules. The existence of a colorable defense
allows a lawyer when acting as an advocate, i.e., once conduct is challenged
in a forum in which another party is arguing that the conduct is unlawful,
the lawyer may argue that the conduct, even if very likely illegal,
is legal. It has no other relevance.
It is of course true that there may be factual or legal uncertainty
about the existence of a material violation, and this uncertainty may
remain after an investigation of the initially reported evidence. But
section 307 specifically requires that the reporting lawyer take “the
evidence” to the board or relevant board committee if the chief
legal officer or chief executive officer does not “appropriately
respond.” Thus, the statute itself mandates reporting up in at
least some cases in which the violation is uncertain. This mandate
makes sense because a concerned and prudent board would want to know
about potential material violations of law.
The fact that a lawyer can advance arguments that would meet the
minimum level of plausibility sufficient to avoid sanction in an adversary
proceeding does not mean that the conduct is probably legal or somewhere
near that middle ground. A public company subject to SEC regulation
is guilty of a civil violation of the securities laws when the preponderance
of evidence supports a finding of a violation. A lawyer acting as an
adviser in transactions and filings subject to SEC disclosure requirements
must advise the company on the basis of whether the available evidence
indicates that a violation is more likely than not. The result of the
SEC’s rule is that both the firm and the lawyer potentially remain
exposed to a significant risk of liability. The application of the “colorable
defense” standard must be limited to the litigation context for
which it is appropriate. The colorable defense standard certainly should
not be used to permit lawyers to advise clients, particularly corporate
clients with fiduciary obligations to their owner-shareholders, to
proceed with conduct that is very likely illegal.
The better response to the problem of uncertain violation would be
to adopt a graduated approach to reporting up, under which there would
be a stricter standard for reporting evidence of a material violation
to the board than for the initial duty to report, when the violation
remained uncertain after investigation. Roger Cramton, Susan Koniak,
and I supported such a graduated approach in our initial comments to
the SEC. For example, the SEC could increase the quantum of evidence
necessary by adopting a “substantial evidence” standard
as triggering a duty to go to the board. The precise formulation could
be debated.
My point is simply that the SEC could have adopted a graduated approach
to the reporting up trigger without weakening the statutory mandate
that “evidence of a material violation” be reported to
the board. In particular, nothing in the statute required or even suggested
that the SEC use a litigation standard – “colorable defense”– to
handle the problem of uncertain violations. Requiring the reporting
up of an uncertain violation in no way interferes with a subsequent
decision by the board to litigate the issue, asserting all nonfrivolous
defenses. Unfortunately, the colorable defense option falls far short
of the statutory mandate. In short, the assertion of a colorable defense
is not an appropriate response to a report of evidence of a material
violation.
c. Law Firms
Section 307 refers to “standards of professional conduct for
attorneys” without addressing the question whether firms in which
attorneys practice are intended to be regulated. The SEC rules appear
directed at individual attorneys. In my view, the rules should be revised
to state explicitly that law firms, not just individual lawyers, “appear
and practice” before the SEC. Similarly, the SEC should add a
rule permitting the censure or reprimand of a law firm and the assessment
of monetary fines when the firm has failed to conform to responsibilities
required by the Commission. The SEC has sought to discipline law firms
in the past in exercising its authority under Rule 2(e). It should
renew these efforts under section 307.
The rationale for including law firms within the SEC rules is straightforward.9 Corporate
clients who hire outside counsel usually understand that they are represented
by the law firm, not any one individual lawyer within the firm. And
in matters of any size or complexity multiple lawyers in the firm,
not just one partner and a few subordinates, are likely to be involved.
Specialized corporate and securities practice involves the participation
of a team of lawyers who bring differing skills and knowledge. Responsibility
for decisions is often divided up or shared in ways that are uncertain
or shifting. The diffusion of responsibility and knowledge leads to
the argument that no one lawyer (or identified group of lawyers) can
be held responsible for what was done.
The law of agency addresses these realities through rules of vicarious
liability and imputed knowledge. If the SEC rules were to apply to
law firms, the question would be whether a law firm might have “evidence
of a material violation” as a result of information possessed
by lawyers in the firm, even if those lawyers do not disclose the information
to other lawyers in the firm who have authority to act for the firm.
In particular, courts have adopted a doctrine of “composite knowledge,” which
attributes to an entity the collective knowledge of its individual
agents even if no one agent had all the knowledge. The SEC has previously
endorsed the composite knowledge idea in exercising its disciplinary
authority against law firms under Rule 2(e).
In my view, not only should the SEC rules apply to law firms, but
the application to law firms should include the idea of composite knowledge.
Absent such an imputation rule, law firms would have an incentive to
decentralize legal work to minimize the number of lawyers with access
to sufficient client information to bring them within the purview of
these rules. As a result, the quality of legal work done in securities
matters as well as compliance with the securities laws would decline,
perhaps in dramatic ways. Moreover, I would not expect a composite
knowledge rule to add significantly to legal costs. Firms often have
good economic reasons for dividing up legal work (in particular, benefits
from specialization), and so they already have a need to coordinate
and monitor the work and information of various lawyers. A failure
to coordinate is itself likely to result in duplication of legal work
that itself would unnecessarily escalate fees, as well as an increased
risk of malpractice. Finally, the increased risk on law firms as a
result of the composite knowledge rule could be mitigated by adopting
a system of reduced penalties for firms with effective compliance programs
and procedures reasonably designed to prevent violations of the SEC
rules.
6. The Noisy Withdrawal Proposal
Noisy withdrawal did not spring fully formed from the imagination
of the SEC. It was a concept invented by the ABA to attempt to reconcile
its (prior to last summer) absolute prohibition on disclosure of client
fraud with its prohibition on aiding and abetting client wrongdoing.
In a comment to Model Rule 1.6, the ABA stated that nothing in that
rule would “prevent the lawyer from giving notice of the fact
of withdrawal, and the lawyer may also withdraw or disaffirm any opinion,
document, affirmation, or the like.” The ABA then endorsed the
noisy withdrawal comment in an ethics opinion in 1992. Using reasoning
only lawyers can appreciate, the ABA claimed that the noisy withdrawal
was an exception to the confidentiality rule because it was not a “disclosure.”
Not only did the ABA create the concept of noisy withdrawal, but
the ABA itself has suggested that in certain circumstances noisy withdrawal
might be required. Comment [10] to Model Rule 1.2 in the Ethics 2000
revisions to the Model Rules states: “In some cases, withdrawal
alone might be insufficient. It may be necessary for the lawyer
to give notice of the fact of withdrawal, and to disaffirm any opinion,
document, affirmation or the like.” A similar statement occurs
in Comment [3] to Model Rule 4.1, which adds: “In extreme cases,
substantive law may require a lawyer to disclose information relating
to the representation to avoid being deemed to have assisted the client’s
crime or fraud.”
The SEC made the mistake of taking the ABA at its word. Initially,
the SEC proposed section 205.3(d)(1), which would require an issuer’s
attorney, in the rare situation in which the attorney reasonably believes
that (1) an issuer has not made an appropriate response to the attorney’s
prior report of evidence of a material violation, and (2) “the
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 the investors:”
to withdraw forthwith from representing the issuer, indicating that
the withdrawal is based on professional considerations; . . . promptly
disaffirm to the Commission any opinion, document, affirmation, representation,
characterization, or the like in a document filed with 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.10
On January 29, 2003, when the Commission adopted its “reporting
up” rule and permissive “reporting out,” it also
proposed an alternative to required “noisy withdrawal” which
would require the issuer, rather than the reporting attorney, to notify
the Commission of the reporting attorney’s withdrawal and also
report “the circumstances related thereto . . . .”11
The major argument against broadening exceptions to confidentiality
is that clients will be deterred from confiding information to their
lawyers. The lack of candor on the part of clients, it is said, will
make it difficult for a lawyer to give informed advice. Moreover, the
ability of the lawyer to disclose client information may diminish client
trust and adversely affect the quality of the relationship and the
single-mindedness with which the lawyer pursues the client’s
interests. If and when the lawyer informs the client that disclosure
is desirable or contemplated, a serious conflict of interest arises
between the lawyer and the client. The relationship ends in bitterness
and a sense of betrayal.
The response to these arguments is several fold. First, some exceptions
to both the professional duty and to the attorney-client privilege
are longstanding and have not had the consequences that are feared.
The people who might be engaged in wrongdoing (corporate managers who
are violating fiduciary duties to the issuer or engaging in law violations
that will harm the issuer as well as investors) have no privilege now
and no legitimate claim of confidentiality. The privilege and the duty
to keep confidences belong to the entity, not the managers or the directors.
Either can be waived by future managers or trustees in bankruptcy.
Moreover, lawyers can disclose confidences in every state to defend
themselves when necessary, even before the filing of actual charges
or a complaint.12 Lawyers can disclose confidences to collect
a fee, when necessary. The crime-fraud exception to the privilege leaves
unprivileged all communications of the client or its agents made in
furtherance of illegality. And in most states, lawyers are already
permitted, and in some cases required, to disclose client fraud. The
self-defense and client-fraud exceptions involve situations that arise
quite frequently and have limited lawyer secrecy from the very beginning.
With all these exceptions to confidentiality and the privilege extant,
the idea that “noisy withdrawal” or the alternative’s “circumstances” provision
would suddenly result in clients not talking to their lawyers is untenable.
Corporate clients (through their agents) confide in corporate lawyers
(to the extent they do, which is now imperfect and always will be)
because corporations need legal advice to carry on their business.
Period. There is no evidence that those broad exceptions have had undesirable
effects on the candor with which clients communicate to lawyers. There
is no evidence whatsoever that corporate clients have avoided lawyers
in those few states that now require disclosure of a client
illegality (e.g., New Jersey) or those states that permit such
disclosure (e.g., Pennsylvania), as distinct from the few that prohibit disclosure
(e.g., District of Columbia). There is no evidence that lawyers in
such states are told less than lawyers in other states. Corporate clients
that function across state lines, as so many do, have a fairly wide
choice of states from which they may secure outside lawyers. No evidence
exists that lawyers in disclosure states have suffered at all or that
the quality of representation or compliance with law in those states
has been reduced. There is no reason to believe that a slight broadening
of the exceptions in situations that arise less frequently will have
any discernible effect.
Second, the available empirical evidence, albeit limited, suggests
that most lawyers and clients expect that confidentiality will be breached
when extremely important interests of third persons or courts would
be impaired.13 Nor is there any indication that clients
are more candid with their lawyers in jurisdictions that have fewer
exceptions to confidentiality than they are in jurisdictions with broader
exceptions. Any objective observer must concede that there is insufficient
solid empirical evidence to support firm conclusions in either direction.
Do New Jersey lawyers, who are required to disclose to rectify a client’s
prior fraud on a third person, have an inferior relationship with their
corporate clients than those in the District of Columbia, where such
disclosure is prohibited? When severe harm is threatened that can be
prevented by disclosure, the reality of that more certain interest
should be preferred to dubious assumptions about effects on client
candor.
Third, the confidentiality interests of public companies regulated
by the SEC have a lesser moral claim for protection than those of private
individuals who are suddenly confronted with a legal problem that requires
a lawyer. Inexperienced individual clients, unfamiliar with legal matters
and fearful of their predicament, have confidentiality interests that
derive in part from constitutional provisions involving individual
rights, especially the special protections given to criminal defendants.
On the other hand, a public corporation “has neither a body that
can be kicked or a soul that can be damned.”
The public companies regulated by the SEC have many public obligations,
operate in a goldfish bowl of scrutiny, and have large experience and
sophistication concerning the hiring, supervision and firing of lawyers.
They are sophisticated repeat-players who use law regularly in carrying
on their business, entering into transactions, dealing with regulatory
authorities, and participating in litigation. They are the major group
of clients who are well informed about the details of the attorney-client
privilege and the exceptions to it, the work-product immunity, and
the professional duty of confidentiality. They are also clients whose
managers may have a large economic incentive to use lawyer secrecy
to delay compliance with regulations or to conceal ongoing violations
of them. This group of clients has many advantages in litigation over
those with less resources, experience and staying power. The social
value of secrecy versus disclosure is less when one is dealing, not
with individual citizens encountering law for the first time, but with
large and informed repeat-player, profit-making organizations that
have strong incentives to delay or conceal compliance with regulatory
requirements that impose substantial costs.
Fourth, there is no evidence that exceptions to confidentiality have
led or will lead to frequent whistle-blowing on the part of lawyers.
Indeed, it is clear that the incidence of whistle-blowing by lawyers
is astonishingly low given the fact that most or all states require
disclosure when a crime or fraud has been perpetrated on a tribunal;
thirty-seven states permit disclosure to prevent a client criminal
fraud; and four populous states require disclosure in that situation.
Disciplinary proceedings for failing to disclose information when required
to do so are virtually non-existent and the same is true for failure
to withdraw when withdrawal is required. On the other hand, law firms
that learn that a client has used their services to defraud others
and who have taken no action to prevent or stop the fraud have frequently
settled malpractice and third-party liability claims for large and
sometimes huge amounts. Available evidence indicates that lawyers who
have discretion to disclose almost always decide not to do so, even
when that course of action risks civil liability. The objection to
rules permitting or requiring disclosure is not that they will lead
to professional discipline, but the effect of the existence of such
rules on the likelihood and success of the malpractice and third-party
liability claims that are the real risk and, prior to the SEC’s
implementation of the Sarbanes-Oxley Act, the principal deterrent force.
Fifth, a lawyer’s public disclosure of the fact of withdrawal
and the general nature of the matter involved, does not waive the client’s
attorney-client privilege. The attorney-client privilege applies only
to communications between lawyers and clients. It does not privilege
the underlying facts. Thus the privilege allows a client (or its lawyer)
to refuse to answer a question in this form: What did your lawyer tell
you? Or, what did you tell your lawyer? The privilege does not allow
a client to refuse to answer questions about a matter simply because
the matter was discussed between lawyer and client.
In particular, a request that the circumstances of withdrawal be
revealed, as the SEC’s alternative proposal requires, is similar
to a discovery request for certain underlying facts. The SEC is not
asking issuers to hand over its lawyer’s written reports or summarize
the oral advice the lawyer gave. The SEC is not asking issuers to describe
the back and forth between lawyer and client on the matter that was
the subject of the report. What the Commission wants from issuers is
two things: One, a statement that the lawyer has resigned, whenever
a resignation is required by the SEC rules; and two, a statement that
the lawyer’s resignation was in connection with the following
matter, including a brief description of the matter, with no requirement
that the issuer repeat or disclose any of what the lawyer actually
said about the matter.
Does this disclosure threaten the attorney-client privilege because
it amounts to requiring the issuer to make this implicit statement: “My
lawyer said that there is evidence that a material violation of law
occurred (is occurring or will occur) in connection with this matter?” We
think not. Courts do not treat the privilege so lightly as to find
waiver based on “implicit” references to lawyer-client
communications. The “circumstances” portion of the Commission’s
proposed alternative should not be changed in the absence of a convincing
showing that the current law of attorney-client privilege adopts the
proposition that “implicit” statements amount to waiver
of the privilege. We know of no such authority and do not believe that
any outlier authority that might exist for such a proposition would
be followed by other courts. The Restatement (Third) of the Law Governing
Lawyers §79, Comment e, states that “[k]nowledge by the
nonprivileged person that the client consulted a lawyer does not result
in waiver, nor does disclosure of nonprivileged portions of a communication
or its general subject matter. Public disclosure of facts
that were discussed in confidence with a lawyer does not waive the
privilege if the disclosure does not also reveal that they were communicated
to the lawyer.” (Emphasis added.)
Finally, securities laws now require issuers to disclose a contingent
liability when that liability is likely to be significant enough to
be of concern to investors. Any such disclosure involves as much of
an implicit statement about what a lawyer told the issuer as the “circumstances” provision
of the alternative proposal of a report by the issuer to the SEC would
require. In sum, eliminating the “circumstances” provision
would render the alternative less protective than the original proposal.
It should not be eliminated. If it is, the original proposal requiring
the reporting lawyer to notify the Commission should be adopted. Whatever
version of the rule is adopted should include the requirement that
the lawyer disaffirm any opinions or representations that the lawyer
reasonably believes are or may be materially false or misleading. That
additional step is required to ensure that these “minimum” standards
are not lower than the fraud provisions of the securities laws or the
ethics rules of most states.
6. Recommendations
My recommendations for Congress and the SEC are the following:
a. Fix the flaws and omissions in the SEC’s current
rules on reporting up. In particular, the initial trigger
should eliminate the double negative formulation; the “colorable
defense” option should be eliminated from the list of “appropriate
responses”; and the rules should make clear that they are applicable
to law firms.
b. Adopt the SEC’s noisy withdrawal proposal. I
have no strong views about which version should be adopted. If the
issuer reporting standard is adopted, however, it should include the
requirement that the issuer report the “circumstances” of
the withdrawal. It should also add a requirement that the reporting
lawyer inform the SEC if the issuer does not.
c. Restore private suits for aiding and abetting. The
threat of liability is in many ways the most effective regulator of
lawyer behavior. I would gladly trade the SEC rules for the overturning
of Central Bank. Although securities class actions have many
problems, those problems should be addressed directly, not by eliminating
causes of action that may have the best chance of deterring corporate
fraud. In addition, Congress should restore the recklessness standard
of knowledge that was eliminated in the Private Securities Litigation
Reform Act.
d. Consider adopting rules similar to the SEC’s rules
for other agencies. The problem of corporate wrongdoing
is of course not limited to securities fraud. The approach taken
by the SEC could easily be applied to lawyers who practice before
other federal agencies. That would not only help deter more corporate
wrongdoing, it would further the goal of providing more uniform standards
of conduct for lawyers.
1 These remarks draw in large part on Roger C. Cramton,
George M. Cohen, & Susan P. Koniak, Legal and Ethical Duties of
Lawyers after Sarbanes-Oxley, Vill. L. Rev. (2004) (forthcoming). In
the interests of brevity, I have omitted most footnotes and have not
indicated which passages are quoted directly from the article.
2 17 C.F.R., Part 205.
3 15 U.S.C. §7245.
4 See the remarks by Senator Michael Enzi during the Senate’s
consideration of § 307: I am usually in the camp that believes
that States should regulate professionals within their jurisdiction.
However, in this case, the State bars as a whole have failed. They
have provided no specific ethical rule of conduct to remedy this kind
of situation. Even if they do have a general rule that applies, it
often goes unenforced. 148 Cong. Rec. at S6555 (Jul. 10, 2002).
5 Michael A. Perino, How Vigorously Will the SEC Enforce
Attorney Up-the-Ladder Reporting Rules? An Institutional Analysis of
Constraints, Norms, and Biases at the Commission, Vill. L. Rev. (2004)
(forthcoming).
6 Central Bank of Denver v. First Interstate Bank of Denver,
511 U.S. 164, 191 (1994).
7 SEC v. National Student Marketing Corp., 457 F.Supp.
682 (D.D.C. 1978).
8 17 C.F.R. §205.3(b)(3).
9 For a persuasive argument in favor of disciplining law
firms, see Ted Schneyer, Professional Discipline for Law Firms?, 77
Cornell L.Rev. 1 (1991).
10 An attorney employed by the issuer (an inside lawyer)
would not be required to resign from employment but would have to stop
working on the matter involved.
11 SEC Release No. 33-8186, “Proposed Rule: Implementation
of Standards of Professional Conduct for Attorneys,” Jan. 29,
2003.
12 See Restatement of the Law Governing Lawyers §64,
cmt. b (discussing the rationale for the “self-defense exception”:
disclosure of confidential information “to defend the lawyer
. . . against a charge or threatened charge by any person that the
lawyer . . . acted wrongfully in the course of representing a client.”
13 See Fred C. Zacharias, Rethinking Confidentiality, 74
Iowa L.Rev. 351, ??? (1989).
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