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Vol. 28, No. 2

ABA, states, and SEC hash out lawyers’ responsibility in corporate settings

by Clifton Barnes

“Noisy” may well be in the ears of the beholder but, by any measure, there has been a thunderous response to “noisy withdrawal” and “up the ladder reporting” rules proposed for corporate attorneys as a result of Sarbanes-Oxley legislation.

The Sarbanes-Oxley Act of 2002 came about due to, and in the wake of, the Enron and WorldCom scandals that shined a bright light on unethical and fraudulent conduct of corporate executives and accountants. This broad corporate governance reform law puts company directors and officers, particularly audit committee members, under the glow of federal regulators’ torches. Lately, however, a beam has illuminated the legal profession.

Securities and Exchange Commission rules requiring attorneys to report corporate misconduct “up the ladder,” arising out of the Sarbanes-Oxley Act, became effective in August of this year. That’s the same month the ABA modified its Model Rules of Professional Conduct to ease barriers as to when attorneys can disclose suspected violations of law by a client.

By a 218-201 vote, the ABA Delegates amended Model Rule 1.6(b) to permit a lawyer to reveal confidential client information to prevent a crime or fraud that is reasonably certain to result in substantial injury to the property or financial interest of another. The ABA also voted to amend Model Rule 1.13 to require a corporate lawyer to report certain violations of law by officers or employees to higher authorities within the organization, unless the lawyer believes that disclosure would not be in the best interest of the organization.

The amendments to Model Rule 1.6 relaxed existing rules regarding client confidentiality and brought the ABA Model Rules, which are often the basis for mandatory state rules, closer to the rules currently followed by 42 states. Meanwhile, the changes to Model Rule 1.13 are consistent with the new “up the ladder” reporting rules adopted by the SEC in accordance with Section 307 of the Sarbanes-Oxley Act.

“Most of us who have been at the bar for some period of time went through law school at a time when it was taught to us that the confidentiality rule [for lawyers and clients] was as strong and as strict as one would have with one’s spiritual leader,” says ABA President Dennis W. Archer, commenting on the closeness of the vote to amend Rule 1.6(b). “We have, for a long time, held that to be very, very sacrosanct and untouchable.”

Archer says similar amendments came before the House of Delegates a couple of years ago but were voted down; what’s different now, he notes, is that scandals such as Enron have reminded us of the need to be especially vigilant.

Section 307 of Sarbanes-Oxley instructs the SEC to adopt a new federal rule requiring all attorneys appearing and practicing before the agency 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.” In addition, if the counsel or officer doesn’t respond appropriately to the information, the attorney is required to go “up the ladder” to the audit committee or another appropriate committee of the board or to the board of directors itself.

As recently amended, ABA Model Rule 1.6 permits (rather than requires) lawyers to reveal confidential client information if the lawyer’s services are being used to commit a crime or fraud. In addition, the revised version of Model Rule 1.13 requires lawyers to report certain violations of law, and other misconduct, up the corporate ladder.

In November 2002, the ABA announced the creation of the Task Force on Implementation of Section 307 of the Sarbanes-Oxley Act of 2002 for the purpose of preparing written comments to the proposed SEC rules. The ABA Task Force, composed of attorneys and judges with expertise in the fields of legal ethics and securities law, prepared and filed its initial comment letter with the SEC on December 18, 2002.

After receiving comments from the ABA and other interested parties, the SEC released its final up-the-ladder reporting rule on January 29, 2003. At the same time, the SEC postponed its decision on a “noisy withdrawal” provision in the proposed rule that would require an attorney to “withdraw” from representation of the company and disclose that withdrawal to the SEC if the response to the lawyer’s initial report were not adequate.

Some in the legal community, including the ABA, believe that the SEC is trying to mandate through regulation what is not in the statute. The postponement of its decision on noisy withdrawal came as a welcome response.

In its January 29 release, the SEC addressed two key concerns raised by the ABA by narrowing the scope of the attorneys the rule applied to and by adopting a more objective trigger mechanism for reporting up the ladder. But the agency declined to withdraw its noisy withdrawal proposal. Instead, the SEC extended the comment period on that proposal for 60 days while issuing, and seeking comments on, an alternative noisy withdrawal proposal as well.“Under this proposed alternative,” writes the SEC, “in the event that an attorney withdraws from representation of an issuer after failing to receive an appropriate response to reported evidence of a material violation, the issuer would be required to disclose its counsel’s withdrawal to the Commission as a material event.”

On April 2, 2003, the ABA filed its second comment letter with the SEC. In that letter, the ABA expressed it continuing opposition to both SEC noisy withdrawal proposals on the grounds that both alternatives would erode the attorney-client privilege. At the same time, the ABA praised the SEC for incorporating a number of significant improvements to its final up-the-ladder reporting rule. In the ABA’s view, the agency “struck the right balance” by requiring attorneys to report corporate violations of law to company officials and permitting the attorneys to further report to the SEC if the company fails to correct the violations.

Although the SEC’s final up-the-ladder reporting rule became effective on August 5, it has not yet issued its final rule on noisy withdrawal.

Archer says communication with the SEC and with Congress is key at this time, as bar leaders convey the message that each state’s highest court, and not the SEC itself, is the proper regulatory body concerning lawyers’ conduct in corporate settings. State regulation is a better choice, he says, because it allows for more “confidence and closeness of oversight,” is more cost-effective and practical, and simply “makes more common sense.” Archer’s hope is that keeping the lines open will encourage the SEC to communicate with the Conference of Chief Justices and with the ABA about how the state courts can best fulfill this responsibility.

Spirited debate

M. Peter Moser, chair of the ABA Section 307 Task Force, says complying with noisy withdrawal provisions might violate state supreme court lawyer ethics rules on client confidentiality. He says lawyers can best advise their clients when clients share information openly, even if concerning ideas that, if acted upon, could violate the law.

“The courts have said that by having complete information, lawyers can guide their clients in lawful conduct and that the public is best served by that guidance,” Moser explains. “When clients fear their secrets are unsafe, they may not seek or obtain the legal advice that heads off behavior that harms the public.”

Some believe that the amendments to the ABA Model Rules of Professional Conduct, proposed by the ABA Task Force on Corporate Responsibility and supported by the Section 307 Task Force, themselves unduly infringe on client confidentiality.

“Intrusions into this principle will only serve to discourage clients from being candid and truthful when dealing with their attorneys,” says A. Thomas Levin, president of the New York State Bar Association, who opposed the amendments. “[This] will hinder the ability of the attorney to provide appropriate legal assistance to the client in the public interest.”

However, ABA Business Law Section Delegates at the Annual Meeting wrote that “what seems to get lost in this argument is the fact that this proposal does not apply to the client in trouble who comes to ask for help. Rather, the proposal applies to the client intent on deceiving the lawyer, and who uses the lawyer to perpetrate a crime or fraud.”

Proponents say that Model Rule 1.6(b), as amended in August, creates a narrow exception to the duty of confidentiality, applying only when the client uses the lawyer’s services to commit a crime or fraud and the crime or fraud is reasonably certain to result in substantial financial injury to someone else.

Lawrence Hamermesh of the ABA Task Force on Corporate Responsibility says the Task Force “unanimously concluded that changes to Rule 1.6 were a modest, sensible way to extend permissive disclosure in a manner that would bring the ABA Model Rules more into line with the comparable rules of a large majority of the states.”

But Levin says the New York Code of Professional Responsibility provisions would better serve the profession than the ABA Model Rules. New York permits attorneys to disclose client confidences to prevent a crime and withdraw opinions upon discovering that the opinion is based on misinformation or is being used to perpetrate fraud. The New York rules also require an attorney to withdraw when the attorney’s services are being used to perpetrate a crime or fraud.

“These provisions are appropriate regulations in such instances without also permitting attorneys to disclose their client’s secrets and confidences,” Levin says.

Sarbanes-Oxley, including the provision requiring attorneys for public corporations to report misconduct up the corporate chain of command, is appropriate, Levin adds. “However, it is another thing altogether to extend these regulations to require attorneys to make public disclosure of their clients’ confidences,” he says. “Such requirements would simply deter clients from including attorneys in discussions or from providing them with accurate information.”

Archer and nine past ABA presidents agree that they have neither experienced nor witnessed any reluctance of clients sharing confidential information with them or their partners. Most of them live in states where the ethics rules are consistent with the new ABA Model Rules, Archer says, and none of the states have experienced any increase in litigation as a result of the ethics rules.

“A close examination of ways to strengthen and clarify the lawyers’ role in making corporate governance more effective is not only appropriate,” the 10 ABA presidents wrote, urging adoption of the Model Rules changes, “but is vital for our profession to respond effectively to the concerns expressed by Congress in the Sarbanes-Oxley Act of 2002 and in related Securities and Exchange Commission rules.”

However, ABA President-Elect Robert Grey Jr. says the ABA is reacting out of fear that government regulators might ask for more from lawyers if they don’t go along with the proposed rules. “This is not the proper time to bow to threats by others who seek to regulate us,” Grey says. “It is not a time to take the position that the core values of the profession are subject to compromise.”

Hamermesh says changes to Model Rules 1.6 and 1.13 “enhance the role of lawyers in promoting corporate responsibility, without sacrificing the core value of confidentiality in the attorney-client relationship.”

He notes that the ABA Task Force on Corporate Responsibility was created to contribute to the dialogue following the Enron bankruptcy, not as a result of Sarbanes-Oxley. In fact, the Task Force issued its preliminary report prior to the date that Sarbanes-Oxley was enacted. He did say that the act “clearly affected the final recommendations” of the Task Force, however.

Levin doubts that the new ABA Model Rules, had they been in effect at the time of Enron’s fall, would have made any difference. “The wrongful conduct which came to light in those instances would not have been prevented by the amended Model Rules,” he says. “Furthermore, existing criminal statutes and ethical rules provided sufficient regulation of conduct, and those statutes and rules should be enforced against those who violated them.”

But having the amended Model Rules before them may prompt the highest courts in the states that do have comparable rules to consider making changes to those rules, Archer says, and may also encourage the other eight states to draft such rules for the first time.

State versions coming?

New York is one state considering its own version of Sarbanes-Oxley, something that has already been done in Connecticut.

Connecticut’s Senate Bill 1035, effective Oct. 1, closely follows Sarbanes-Oxley and provides that compliance with the certification requirements of the federal act satisfies the certification requirements in the state. Penalties include fines up to $5 million and/or 20 years in prison. The law, which the Connecticut Bar Association Business Law Section opposed, applies to each officer of a corporation either organized in Connecticut or authorized to transact business in that state.

It’s unknown to what extent Sarbanes-like legislation will continue to move into the states. “I think one of the countervailing forces will be the sluggish economy,” says Jennifer Boese, former senior government relations coordinator at the State Bar of Wisconsin. “Legislators will have to balance increased regulations, such as those under Sarbanes-Oxley, with their desire to grow the economies of their respective states.”

While Sarbanes-Oxley is essentially a securities law, Boese says, it has been seen as more of a general corporate governance law. “I’ve heard individuals in Wisconsin state government mention Enron as a basis for questioning whether certain business-related legislation is good or not,” she says.

Waiting and watching

All types of lawyers, not just securities lawyers, are learning how Sarbanes-Oxley may affect them. It’s clear that it’s not only securities law violations that are reportable. “As with any new piece of legislation, we’re trying to figure out exactly what the act means,” says Jack Derrick, chair of the North Carolina Bar Association’s Corporate Counsel Section. “We don’t really know yet. There aren’t any court decisions on it. At the [continuing legal education seminars] we’ve had about it, the speakers simply admonish everyone to be careful.”

Derrick says he hasn’t seen much anxiety over Sarbanes-Oxley. “I think most of us believe we work for good companies who are good corporate citizens and, by and large, that’s true,” he says.

Derrick says some people say Sarbanes-Oxley is a horrible thing, and some say they’ve always done business that way, so it won’t impact them much. “I think the truth probably lies somewhere in between,” he says. “My place on that continuum varies day to day.”

Most lawyers understand that their clients extend to the shareholders and the board, he adds, and not just the person down the hall who may be considered the lawyer’s superior. “Personally, I think I have a good feel for who my clients are and I have an obligation to say ‘no’ on occasion,” he says. “I believe most lawyers felt that same way before Sarbanes-Oxley came up.”

Similarly, attorney Ed Mendrzycki, who made a presentation on Sarbanes-Oxley at an ABA Center for Professional Responsibility event earlier this year, says lawsuits against lawyers when corporate clients fail and investors and creditors lose money are not new, either. “Many of the issues that the Sarbanes-Oxley Act will create for lawyers are ones that lawyers have faced for years: client quality, client confidentiality, and conflicts of interest,” he says.

A lot still remains to be seen about the impact of Sarbanes-Oxley, Boese says, “but I think it’s safe to say people are paying attention.”