Securities and Exchange Commission,

Federal Register: December 2, 2002 (Volume 67, Number 231)Proposed RulesPage 71669-71707From the Federal Register Online via GPO Access [wais.access.gpo.gov]

DOCID:fr02de02-47

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Part III

Securities and Exchange Commission

17 CFR Part 205

Implementation of Standards of Professional Conduct for Attorneys; Proposed Rule

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 205

Release Nos. 33-8150; 34-46868; IC-25829; File No. S7-45 -02RIN 3235-AI72

Implementation of Standards of Professional Conduct for Attorneys

AGENCY: Securities and Exchange Commission.

ACTION: Proposed rule.

SUMMARY: The Securities and Exchange Commission (``Commission'') is soliciting comments on a proposed rule that would establish standards of professional conduct for attorneys who appear and practice before the Commission on behalf of issuers. Section 307 of the Sarbanes-Oxley Act of 2002 requires the Commission to prescribe minimum standards of professional conduct for attorneys appearing and practicing before the Commission in any way in the representation of issuers. The standards must include a rule requiring an attorney to report evidence of a material violation of securities laws 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); and, if they do not respond appropriately to the evidence, requiring the attorney to report the evidence to the audit committee, another committee of independent directors, or the full board of directors. Proposed Part 205 responds to this directive and is intended to protect investors and increase their confidence in public companies by ensuring that attorneys who work for those companies do not ignore evidence of material misconduct.

DATES: Comments should be received on or before December 18, 2002.

ADDRESSES: To help us process and review your comments efficiently, comments should be sent by hard copy or by e-mail, but not by both methods.

Comments sent by hard copy should be submitted in triplicate to Jonathan G. Katz, Secretary, Securities and Exchange Commission, 450 Fifth Street, NW, Washington, DC 20549-0609. Alternatively, comments may be submitted electronically to the following e-mail address: rule- comments@sec.gov. All comment letters should refer to File No. 33- 8150.wp; this file number should be included on the subject line if e- mail is used. All comment letters received will be available for public inspection and copying in the Commission's Public Reference Room at the same address. Electronically submitted comments will be posted on the Commission's internet Web site (http://www.sec.gov).\1\

\1\ The Commission does not edit personal identifying information, such as names or electronic mail addresses, from electronic submissions. Interested persons submitting comments should only submit information that they wish to make publicly available.

FOR FURTHER INFORMATION CONTACT: Timothy N. McGarey or Edward C.

Schweitzer at 202-942-0835.

SUPPLEMENTARY INFORMATION: The Commission is proposing to add a new Part 205 to Title 17, Chapter II, of the Code of Federal Regulations \2\ establishing standards of professional conduct for attorneys who appear and practice before the Commission in the representation of issuers, under the Securities Act of 1933, the Securities Exchange Act of 1934, the Investment Company Act of 1940, the Investment Advisers Act of 1940, and the Sarbanes-Oxley Act of 2002.

\2\ 17 CFR part 205.

Table of Contents

I. Purpose of This Rule Proposal II. Commission Initiatives to Establish Professional Standards for Attorneys Appearing and Practicing Before the Commission

A. The Role of Attorneys Who Appear before the Commission.

B. The Commission's Ability to Discipline Attorneys under Rule 102(e).

C. Prior Commission Consideration of an Attorney's Obligation to Report Corporate Misconduct to Management. III. Section 307 of the Sarbanes-Oxley Act IV. Proposed Part 205

A. General Overview

B. Summary of Part 205 V. Section-By-Section Discussion of the Proposed Rule and Request for Comments VI. Paperwork Reduction Act VII. Costs and Benefits VIII. Effect on Efficiency, Competition and Capital Formation IX. Initial Regulatory Flexibility Analysis X. Small Business Regulatory Enforcement Fairness Act XI. Statutory Basis and Text of Proposed Part 205

I. Purpose of This Rule Proposal

The purpose of this release is to solicit comments on proposed Part 205,\3\ which prescribes Standards of Professional Conduct for Attorneys who appear and practice before the Commission in any way in the representation of issuers.

\3\ Proposal 17 CFR part 205.

Section 307 of the Sarbanes-Oxley Act of 2002 (the ``Act'') (15 U.S.C. 7201 et seq.) mandates that the Commission

shall issue rules, in the public interest and for the protection of investors, setting forth minimum standards of professional conduct for attorneys appearing and practicing before the Commission in any way in the representation of issuers, including a rule--

  (1) Requiring an attorney 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); and

  (2) If the counsel or officer does not appropriately respond to the evidence (adopting, as necessary, appropriate remedial measures or sanctions with respect to the violation), requiring the attorney to report the evidence to the audit committee of the board of directors of the issuer or to another committee of the board of directors comprised solely of directors not employed directly or indirectly by the issuer, or to the board of directors.

The proposed rule responds to this directive.\4\

\4\ The Act mandates that the Commission issue a rule establishing such minimum standards of conduct for attorneys within 180 days of its enactment. The Act was signed into law by President Bush on July 30, 2002. Accordingly, the new rule must be issued by January 26, 2003. The Commission may, in the event it determines it appropriate in light of the mandate of Section 307, supplement the rule establishing minimum standards after that date.

II. Commission Initiatives to Establish Professional Standards for Attorneys Appearing and Practicing Before the Commission

A. The Role of Attorneys Who Appear Before the Commission

Attorneys play a varied and crucial role in the Commission's processes. Attorneys prepare, or assist in the preparation of, materials that are filed with or submitted to the Commission by, or on behalf of, issuers. These materials are relied upon by public investors in making their investment decisions. Thus, the Commission, and the investing public, must be able to rely upon the integrity of in-house and retained lawyers who represent issuers.

Attorneys also play an important and expanding role in the internal processes and governance of issuers, ensuring compliance with applicable reporting and disclosure requirements (including, inter alia, requirements mandated by the federal securities laws). During the floor debate on the amendment that was subsequently adopted and enacted as Section 307 of the Act, Senator John Edwards emphasized the important function attorneys play at public companies. ``This amendment is about making sure those lawyers, in addition to the accountants and executives in the

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company, don't violate the law and, in fact, more importantly, ensure that the law is being followed.'' \5\ Unfortunately, the actions of some attorneys have drawn increasing scrutiny and criticism in light of recent events demonstrating that at least ``some lawyers have forgotten their responsibility.'' \6\ Moreover, existing state ethical rules have not proven to be an effective deterrent to attorney misconduct.\7\ The July 16, 2002 Preliminary Report of the American Bar Association Task Force on Corporate Responsibility (hereinafter the ``Cheek Report'') noted that ``a disturbing series of recent lapses in corporations involving false or misleading financial statements and alleged misconduct by executive officers' has compromised investors' confidence in both the ``quality and the integrity'of the governance of public companies.\8\ Indeed, the Task Force concluded that ``the system of corporate governance at many public companies has failed dramatically.'' Moreover, the Task Force's preliminary report acknowledges that attorneys representing and advising corporate clients bear some share of the blame for this failure.\9\

\5\ See remarks by Senator John Edwards, 148 Cong. Rec. S6552 (July 10, 2002).

\6\ Id. at S6551. See also Speech by SEC Chairman Harvey L. Pitt: Remarks Before the Annual Meeting of the American Bar Association's Business Law Section (Aug. 12, 2002) (``recent events have refocused our attention on the need for the profession to assist us in ensuring that fundamental tenets of professionalism, ethics and integrity work to ensure investor confidence in public companies.''), available at http://www.sec.gov/news/speech/spch579.htm .

\7\ See remarks by Senator Michael Enzi, 148 Cong. Rec. at S6555 (``I am usually in the camp that believes that [s]tates should regulate professionals within their jurisdiction. However, in this case, the [s]tate 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.'').

\8\ See Cheek Report at 3-4.

\9\ See Cheek Report at 7 (``It is a clear failure of corporate responsibility if executive officers aware of potential accounting irregularities sell millions of dollars of stock to public investors who are unaware of [earnings misstatements and self-dealing by corporate officers]. It is a clear failure of corporate responsibility for insiders to borrow enormous amounts from their companies without adequate security beyond inflated stock of the company itself. And it is a clear failure of corporate responsibility when outside directors, auditors and lawyers, who have important roles in our system of independent checks on the corporation's management, fail to avert or even discover--and sometimes actually condone or contribute toward the creation of--the grossest of financial manipulations and fraud.'').

Moreover, foreign attorneys are playing an ever greater role in connection with their representation of issuers making Commission filings. With the globalization of the U.S. capital markets, there has been a marked increase in the number of companies from non-U.S. jurisdictions registering securities with the Commission.\10\ At present, there are over 1,300 foreign private issuers from 59 countries that are filing reports with the Commission under the Exchange Act, as compared with approximately 400 issuers from less than 30 countries in 1990. As a result, it is important to address how the proposed rule would apply to these foreign attorneys.

\10\ The Commission realizes that the application of Section 307 and the rules we are proposing under Part 205 to foreign law firms, multijurisdictional law firms, and foreign lawyers employed by those law firms and foreign registrants, raises a number of significant and difficult issues. We are requesting comment on a broad range of questions in this area, including whether foreign law firms and foreign lawyers should be exempt from Part 205.

B. The Commission's Ability To Discipline Attorneys Under Rule 102(e)

Rule 102(e) of the Commission's Rules of Practice has been the primary vehicle available to the Commission to protect its processes and ensure the competence of professionals (including attorneys) who appear and practice before it.\11\ The Commission adopted Rule 102(e) as a ``means to ensure that those professionals, on whom the Commission relies heavily in the performance of its statutory duties, perform their tasks diligently and with a reasonable degree of competence.'' \12\ The rule permits the Commission to initiate disciplinary proceedings against attorneys who lack integrity or competence, engage in improper professional conduct,\13\ or who are determined to have violated provisions of the federal securities laws. The sanctions available in those proceedings include censure, temporary suspension, and permanent bar.

\11\ Rule 2(e), the predecessor to Rule 102(e), was promulgated in 1935. Rule 2(e) was redesignated Rule 102(e) in 1995. For the sake of uniformity, the rule will be referred to throughout this release as Rule 102(e).

\12\ Touche Ross & Co. v. SEC, 609 F.2d 570, 582 (2d Cir. 1979). The Commission's existing Rule 102 addresses the conduct of attorneys, accountants, engineers and other professionals or experts who appear or practice before the Commission. 17 CFR 201.102(e)(2) and (f)(2).

\13\ Rule 102(e) does not establish professional standards. Rather, the rule enables the Commission to discipline professionals who have engaged in improper professional conduct by failing to satisfy the rules, regulations or standards to which they are already subject, including state ethical rules governing attorney conduct, or generally accepted accounting principles (GAAP) or generally accepted auditing standards (GAAS) governing the conduct of accountants.

Professionals against whom the Commission has instituted Rule 102(e) proceedings (particularly accountants) have challenged the Commission's authority to promulgate the rule. Every court that has ever considered the issue has concluded that the Commission possessed the authority to promulgate Rule 102(e), and the courts have recognized that it is appropriate for the Commission to use a disciplinary mechanism like Rule 102(e) to protect the integrity of its processes and to encourage professionals to adhere to minimum standards of competence.\14\ Nevertheless, as noted below, the Commission's use of Rule 102(e) has proven to be controversial,\15\ and until enactment of the Act, the Commission has never had express statutory authority to promulgate a rule establishing standards of conduct for attorneys representing issuers.\16\

\14\ See Touche Ross v. SEC, 609 F.2d 570 (2d Cir. 1979) (Rule 2(e) was validly promulgated pursuant to the Commission's ``broad authority'' to adopt rules and regulations necessary to carry out the Commission's designated functions); Davy v. SEC, 792 F.2d 1418 (9th Cir. 1986)(concluding that the Commission had statutory authority to adopt Rule 102(e)); Checkosky v. SEC, 23 F.3d 452, 456 (D.C. Cir. 1994) (``'There can be little doubt that the Commission, like any other institution in which lawyers or other professionals participate, has authority to police the behavior of practitioners before it''') (Silberman, J., quoting Polydoroff v. ICC, 773 F.2d 372, 374 (D.C. Cir. 1985)).

\15\ Compare Norman S. Johnson & Ross A. Albert, ``Deja Vu All Over Again'': The Securities and Exchange Commission Once More Attempts to Regulate the Accounting Profession Through Rule 102(e) of its Rules of Practice, 1999 Utah L. Rev. 553, with Paul Gonson, The 1998 Amendment to SEC Rule 102(e) Will Withstand Judicial Scrutiny, 1999 Utah L. Rev. 609.

\16\ In 1998, in response to the opinion from the U.S. Court of Appeals for the District of Columbia Circuit in Checkosky v. SEC, in which the Court criticized the Commission's interpretation of Rule 102(e) to the extent it was applied to accountants, the Commission amended Rule 102(e) to clarify the Commission's standard for determining when accountants engage in ``improper professional conduct''. The Commission did not at that time amend the rule to address how it would apply the rule to misconduct by attorneys.

C. Prior Commission Consideration of an Attorney's Obligation to Report Corporate Misconduct to Management Even before enactment of the Act, the Commission had addressed the responsibility of attorneys appearing and practicing before the Commission to report to management evidence of misconduct of which they become aware during the course of their representation of a public company.

In a 1981 decision, In the Matter of William R. Carter, Charles J. Johnson, Jr., 22 S.E.C. Docket No. 292, 1981 WL 384414, the Commission reversed an initial decision by a Commission Administrative Law Judge that concluded that two attorneys who failed to correct misstatements contained in a client's press releases and Commission filings concerning earnings had aided and abetted their client's violation of the federal securities laws. The Commission

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concluded that existing ethical standards governing the conduct of attorneys did not unambiguously proscribe the behavior in question, and the Commission therefore did not sanction the attorneys. Nevertheless, the Commission announced that in the future it would interpret Rule 102(e) to require an attorney who learns that a client is ``engaged in a substantial and continuing failure to satisfy'' disclosure requirements prescribed by the federal securities laws to ``take[] prompt steps to end the client's noncompliance'' in order to avoid violating professional standards. 1981 WL 384414 at *29-*31.\17\ The Commission indicated that the attorney can initially simply ``counsel[] accurate disclosure'' by the client. However, in the event the client does not cure the deficiency, the Commission stated that an attorney must take additional ``more affirmative steps'' including possibly a ``direct approach to the board of directors or one or more individuals or officers'' or an attempt ``to enlist the aid of other members of the firm's management'' to correct the deficiency. Id. at *31. ``What is required, in short, is some prompt action that leads to the conclusion that the lawyer is engaged in efforts to correct the underlying problem, rather than having capitulated to the desires of a strong- willed, but misguided client.'' Id. at *31.

\17\ The Commission specifically opined that ``[w]hen a lawyer with significant responsibilities in the effectuation of a company's compliance with the disclosure requirements of the federal securities laws becomes aware that his client is engaged in a substantial and continuing failure to satisfy those disclosure requirements, his continued participation violates professional standards unless he takes prompt steps to end the client's noncompliance.'' 1981 WL 384414 at *29.

The Commission announced in its decision in Carter and Johnson that it would solicit comments from the public regarding whether the newly articulated interpretation of ``unethical or improper professional conduct'' should be expanded or modified. Id. at *28. The release doing so stated that, based on the comments received, the Commission might or might not expand or modify its interpretation of the phrase ``unethical or improper professional conduct'' in Rule 102(e). ``Until that time, the present interpretation will govern all similar circumstances for purposes of proceedings pursuant to Rule [102](e) if the conduct occurred after February 28, 1981''--the date on which the Commission announced its interpretation in Carter and Johnson.\18\ The Commission's announcement in Carter and Johnson of the standard to be applied to similar cases in the future and its request for written comments engendered strong opposition from the private bar. The Commission, however, never amended the interpretation of ``unethical or improper professional conduct'' articulated in Carter and Johnson.\19\

\18\ Request for Comments on Standard of Conduct Constituting Unethical or Improper Professional Practice Before the Commission, 1981 SEC LEXIS 730 at *3-*4 (Sept. 21, 1981).

\19\ In a previous case, In the Matter of Keating, Muething & Klekamp, 1979 SEC LEXIS 1186 (July 2, 1979), the Commission instituted and settled a Rule 102(e) proceeding against a law firm which prepared Commission filings by a financial client. The Commission concluded that virtually every member of the firm knew that disclosures contained in the client's filings were inadequate and misleading, but that the internal procedures at the firm were inadequate to ensure that this information was properly evaluated in connection with the firm's preparation of Commission filings or reflected within the filings. The Commission specifically opined that ``[a] law firm has a duty to make sure that disclosure documents filed with the Commission include all material facts about a client of which it has knowledge as a result of its legal representation of that client.'' Id. at *27.

Subsequently, the Commission's then-General Counsel expressed concern in a speech regarding the Commission's lack of either ``the time or expertise'' to fashion a code of professional conduct for attorneys appearing and practicing before it.\20\ He further suggested that the Commission should focus its attention on bringing Rule 102(e) proceedings against attorneys when the alleged misconduct represents ``a violation of established state law ethical or professional misconduct rules and has a direct impact on the Commission's internal processes,'' and indicated that the Commission generally should not institute Rule 102(e) proceedings against attorneys absent a judicial determination that the lawyer has violated the federal securities laws.\21\

\20\ See Edward F. Greene, Lawyer Disciplinary Proceedings before the Securities and Exchagne Commission, Remarks to the New York County Lawyers' Association, (Jan. 18, 1982), Fed. Sec. L. Rep. (CCH) ] 83,089.

\21\ See Fed. Sec. L. Rep. (CCH) ] 83,089 (``When the attorney's alleged misconduct is predicated on theories of aiding and abetting liability, as it almost always is when the conduct involves the preparation and filing of documents, and the Commission is also proceeding against the principals in a simultaneous injunctive action, I believe that the wisest course for the Commission to follow is to add the attorney to the injunctive action as a co- defendant. If that is not possible for unusual reasons, then an administrative proceeding under Rule [102(e)] could be commenced. And in those administrative proceedings based upon violations of standards of ethical or professional conduct, I believe that the Commission should use existing state law standards.'').

In 1988, the Commission issued a release announcing adoption of an amendment to Rule 102(e) to provide for public proceedings initiated under the rule. See Disciplinary Proceedings Involving Professionals Appearing or Practicing Before the Commission, 1988 SEC LEXIS 1365 (July 7, 1988). The majority of the release discussed the basis for the Commission's conclusion that the benefit of conducting such proceedings in public outweighed the competing privacy concerns. The Commission noted in the release that it ``has generally utilized Rule [102(e)] proceedings against attorneys only where the attorney's conduct has already provided the basis for a judicial or administrative order finding a securities law violation in a non-rule [102(e)] proceeding'' and that it would continue to follow this policy. Id. at *22.

Nevertheless, the Commission has continued to assess the actions of attorneys who learn of misconduct by public company clients outside of the context of Rule 102(e). In a subsequent case, In the Matter of George C. Kern, Jr., 50 S.E.C. 596, 1991 SEC LEXIS 1222 (June 21, 1991), a Commission Administrative Law Judge concluded that an attorney serving both as outside counsel and as a director of a company caused his client to violate the Exchange Act by failing to amend his client's prior filing with the Commission to reflect more recent developments during the course of a tender offer. The ALJ nevertheless concluded that he lacked authority to enter an order directing future compliance pursuant to Section 15(c)(4) of the Exchange Act, and discontinued the proceedings. The Commission affirmed the order discontinuing proceedings.

In another case, In the Matter of John H. Gutfreund, Thomas W. Strauss and John W. Meriwether, 51 S.E.C. 93 (Dec. 3, 1992), the Commission issued a report of investigation pursuant to its authority under Section 21(a) of the Exchange Act (15 U.S.C. 78u(a)) concerning the actions of the chief legal officer at a broker-dealer who was apprised of criminal wrongdoing by a corporate officer. While the chief legal officer was not named as a respondent, the Commission issued the report to emphasize its views on the supervisory responsibilities of legal and compliance officers who learn of misconduct by their employer or by a co-worker. The Commission concluded that such individuals are ``obligated to take affirmative steps to ensure that appropriate action is taken to address the misconduct,'' including ``disclosure of the matter to the entity's board of directors, resignation from the firm, or disclosure to regulatory authorities.'' Id. at 113-114.\22\

\22\ In 1997, the Commission issued another report of investigation in a matter involving officers and directors of W.R. Grace Co. The Commission concluded that these individuals failed to take action to ensure full and prompt disclosure of substantial retirement benefits the company had agreed to pay to its former CEO in the company's annual report, a 10K filing, and a proxy statement. See Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934 Concerning the Conduct of Certain Former Officers and Directors of W.R. Grace & Co., 1997 SEC LEXIS 2038 (Sep. 30, 1997). The Commission issued the report in order ``to emphasize the affirmative responsibilities of corporate officers and directors to ensure that the shareholders whom they serve receive accurate and complete disclosure of information required by the proxy solicitation and periodic reporting provisions of the federal securities laws.'' 1997 SEC LEXIS 2038, *3. Although none of the officers and directors named in the matter were attorneys, the report emphasizes the affirmative duty of an issuer's management to correct misconduct and make full disclosure of relevant matters to investors. See also cases discussed infra in n.31 and accompanying text.

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In sum, while the Commission has opined on a case-by-case basis that lawyers appearing and practicing before the Commission have an obligation to report corporate misconduct to appropriate officers and directors, it has not adopted comprehensive standards directing attorneys to report instances of misconduct.

III. Section 307 of the Sarbanes-Oxley Act

In the wake of sensational revelations concerning Enron and other public companies, a group of legal academics forwarded a letter to Chairman Pitt urging the Commission to impose an ``up the ladder'' reporting requirement on attorneys that would oblige attorneys who learn of misconduct at public companies to report this information to the management of the company.\23\ In a March 28, 2002 response, the Commission's then-General Counsel did not take issue with the academics' proposals but noted that there are good reasons why ``a significant change in established practice should be undertaken in the context of Congressional legislation, as opposed to agency rulemaking.''\24\ Senator John Edwards, the sponsor of Section 307, learned of this exchange of letters and concluded that it was time for Congress to act to provide a context of Congressional legislation for Commission rules imposing an ``up the ladder'' reporting requirement on attorneys representing public companies.\25\

\23\ See March 7, 2002 letter to Chairman Pitt from Richard Painter, et al., at http://www.abanet.org/buslaw/corporateresponsibility/responsibility_relatedmat.html .

\24\ See March 28 letter from David Becker to Painter, et al., at http://www/abanet.org/buslaw/corporateresponsibility/responsibility_relatedmat.html .

\25\ See 148 Cong. Rec. S6524-02, S6551-6552 (July 10, 2002).

Section 307 of the Act requires the Commission to promulgate minimum ethical standards for attorneys representing issuers, including an ``up the ladder'' reporting requirement on attorneys as originally proposed by the Commission in Carter and Johnson \26\ as a means of addressing the same types of concerns regarding attorney behavior and shareholder protection as were described in the Cheek Report. The provision directs the Commission to issue rules applicable to all attorneys appearing and practicing before the Commission in the representation of issuers that require attorneys initially to report evidence of a material violation to appropriate officers within the issuer and, thereafter, to the highest authority within the issuer if the initial report does not result in an appropriate response.\27\

\26\ See 148 Cong. Rec. S6552 (July 10, 2002).

\27\ Although legislative history for Section 307 is limited, comments made by its sponsors in speeches delivered on the Senate floor suggest that the sponsors' immediate goal was to impose an ``up the ladder'' reporting system upon lawyers representing issuers. See remarks by Senator John Edwards, 148 Cong. Rec. S6552 (July 10, 2002) (``This amendment is about making sure those lawyers, in addition to the accountants and executives in the company, don't violate the law and, in fact, more importantly, ensure that the law is being followed. * * * If you find out that the managers are breaking the law, you must tell them to stop. If they won't stop, you go to the board of directors, which represents the shareholders, and tell them what is going on. If they won't act responsibly and in compliance with the law, then you go to the board and say something has to be done; there is a violation of the law occurring. It is basically going up the ladder, up the chain of command. * * * This amendment acts in a very simple way. It basically instructs the SEC to start doing exactly what they were doing 20 years ago, to start enforcing this up-the-ladder principle.''). See also id. at S6555 (comments by Senator Enzi) (``When their counsel and advice is sought, attorneys should have an explicit, not just an implied, duty to advise the primary officer and then, if necessary, the auditing committee or the board of directors of any serious legal violation of the law by a corporate agent. Currently, there is no explicit mandate requiring this kind of conduct. It is clearly in the best interest of their client to disclose this type of information'') and S6556 (comments by Senator Corzine) (``The bottom line is this. Lawyers can and should play an important role in preventing and addressing corporate fraud. Our amendment seeks to ensure that. It seeks to go back to the old way: when lawyers know of illegal actions by a corporate agent, they should be required to report the violation to the corporation.'').

IV. Proposed Part 205

A. General Overview

Proposed Part 205 responds to Congress' mandate that the Commission adopt an effective ``up the ladder'' reporting system, and evidences the Commission's intention to implement a robust system in this regard. As set forth in greater detail in the discussion below, the proposed rule would adopt an expansive view of who is appearing and practicing before the Commission. This approach recognizes that attorneys interact with the Commission on behalf of issuer clients in a number of ways, and protects investors by reaching attorney conduct that may threaten the Commission's processes and harm shareholders.

In addition to a rigorous ``up the ladder'' reporting requirement, the proposed rule incorporates several corollary provisions that are not explicitly required by Section 307, but which the Commission believes are important components of an effective ``up the ladder'' reporting system. Under certain circumstances, these provisions permit or require attorneys to effect a so-called ``noisy withdrawal'' and to notify the Commission that they have done so and permit attorneys to report evidence of material violations to the Commission. These provisions embody ethical principles that legal commentators and the ABA have been considering for years,\28\ and are similar in important respects to ethical rules that have already been enacted in a number of jurisdictions. At the same time, the proposed rule does not attempt to articulate a comprehensive set of standards regulating all aspects of the conduct of attorneys who appear and practice before the Commission. The Commission does not intend to supplant state ethics laws unnecessarily, particularly in areas (e.g., safeguarding of client assets, escrow procedures, advertising) where the Commission lacks expertise. The Commission believes that the proposed rule will deter instances of attorney and issuer misconduct and where misconduct has occurred, minimize its impact upon issuers and their shareholders.

\28\ Indeed, the ABA's ongoing evaluation of the Cheek Report focuses, in large measure, upon a provision which would impose a reporting obligation comparable to that in proposed Part 205. Cheek Report at 27-30.

At the same time, the Commission does not want the rule to impair zealous advocacy, which is essential to the Commission's processes. The Commission also does not want the rule to discourage issuers from seeking and obtaining effective and creative legal advice. Finally, the Commission is cognizant of the ongoing efforts by the ABA and other organizations to address many of the same issues that are covered by the rule, and will continue to monitor those efforts and review the content and operation of the rule, particularly insofar as any measure adopted by the ABA or some other organization or entity extends beyond the scope of Section 307.

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B. Summary of Part 205

Section 205.3(b) of proposed Part 205 prescribes the duty of an attorney who appears or practices before the Commission in the representation of an issuer to report evidence of a ``material violation.'' The rule's reporting obligation is triggered only when an attorney becomes aware of information that would lead a reasonable attorney to believe a material violation has occurred, is occurring, or is about to occur, thus limiting the instances in which the reporting duty prescribed by the rule will arise to those where it is appropriate to protect investors. The attorney is initially directed to make this report to the issuer's chief legal officer (``CLO''), or to the issuer's CLO and chief executive officer (``CEO''). Absent exigent circumstances, the attorney is also obligated to take reasonable steps to document his or her reports, as well as any response received from the CLO or CEO and retain the documentation for a reasonable time. Keeping such documentation will protect the attorney in the event his or her compliance with the proposed rule is put in issue in some future proceeding.

When presented with a report of a possible material violation, the rule obligates the issuer's CLO to conduct a reasonable inquiry to determine whether the reported material violation has occurred, is occurring, or is about to occur. A CLO who reasonably concludes that there has been no material violation must notify the reporting attorney of this conclusion. A CLO who concludes that a material violation has occurred, is occurring, or is about to occur must take reasonable steps to ensure that the issuer adopts appropriate remedial measures and/or sanctions, including appropriate disclosures. Furthermore, the CLO is required to report ``up the ladder'' within the issuer what remedial measures have been adopted or sanctions imposed and to advise the reporting attorney of his or her conclusions.

A reporting attorney who receives an appropriate response within a reasonable time and has taken reasonable steps to document his or her report and the response to it has satisfied his or her obligations under the rule. In the event a reporting attorney does not receive an appropriate response within a reasonable time, he or she must report the evidence of a material violation to the issuer's audit committee, or (if the issuer does not have an audit committee) to another committee of independent directors, or (if the issuer does not have another committee of independent directors) to the full board. If the attorney reasonably believes that it would be futile to report evidence of a material violation to the CLO and CEO, the attorney may report directly to the issuer's audit committee, or (if the issuer does not have an audit committee) to another committee of independent directors, or (if the issuer does not have another committee of independent directors) to the full board. A reporting attorney who has reported a matter all the way ``up the ladder'' within the issuer and who reasonably believes that the issuer has not responded appropriately must take reasonable steps to document the response, or absence thereof.

The proposed rule would also provide an alternative system for reporting evidence of material violations. See Section 205.3(c). Issuers may, but are not required to, establish a qualified legal compliance committee (``QLCC'') composed of at least one member of the issuer's audit committee, and two or more independent members of the issuer's board for the purpose of investigating reports of material violations made by attorneys. A QLCC must have the authority and the responsibility to conduct any necessary inquiry into the reported evidence, to require the issuer to adopt appropriate remedial measures to prevent an ongoing, or alleviate a past, material violation, and to notify the Commission of the material violation and disaffirm any tainted document submitted to the Commission. The QLCC would be required to notify the board, the CLO, and the CEO of the results of any inquiry and the remedial measures the QLCC decided were appropriate. In the event the issuer fails to take remedial measures as directed by the QLCC, each member of the QLCC, the CLO, and the CEO would each be individually responsible for notifying the Commission of the material violation and for disaffirming any tainted submission to the Commission. An attorney would satisfy his reporting obligation under the rule by reporting evidence of a material violation to a QLCC. Additionally, a CLO who receives a report of a material violation may refer the report to a QLCC in lieu of conducting his or her own inquiry.

Paragraph 205.3(d) discusses the obligations of an attorney who has not received an appropriate response from the issuer. The provision distinguishes between outside attorneys retained by the issuer and attorneys employed by the issuer. Outside attorneys who have made a report and have not received an appropriate response and who reasonably believe that the reported material violation is ongoing or is about to occur and is likely to result in substantial injury to the financial interest of the issuer or of investors are required to withdraw from the representation, notify the Commission of their withdrawal, and disaffirm any submission to the Commission that they have participated in preparing which is tainted by the violation. In-house attorneys employed by an issuer who reasonably believe that the reported violation is ongoing or is about to occur and is likely to result in substantial injury to the financial interest of the issuer or of investors are required to disaffirm any tainted submission they have participated in preparing, but are not required to resign. In the event an attorney reasonably believes that a material violation has already occurred and has no ongoing effect, the attorney is permitted, but not required, to take these steps, so long as he or she also reasonably believes that the reported material violation is likely to have caused substantial injury to the financial interest of the issuer or of investors. Finally, an attorney formerly employed or retained by an issuer who reasonably believes that he or she has been discharged because he or she fulfilled the reporting obligation imposed by the rule may, but is not required to, notify the Commission of his or her belief that he or she was discharged for reporting evidence of a material violation and also disaffirm in writing any submission to the Commission that he or she participated in preparing which is tainted by the violation. A notification to the Commission under this section does not breach the attorney-client privilege.

Paragraph 205.3(e) sets forth the specific circumstances under which an attorney is authorized to disclose confidential information related to his or her appearance and practice before the Commission in the representation of an issuer. Pursuant to this provision, an attorney may use the documentation he or she has prepared under the rule to defend against charges of attorney misconduct. Paragraph 205.3(e)(2) also allows an attorney to reveal confidential information to the extent necessary to prevent the commission of an illegal act which the attorney reasonably believes will result either in perpetration of a fraud upon the Commission or in substantial injury to the financial or property interests of the issuer or investors. Similarly, the attorney may disclose confidential information to rectify an issuer's illegal actions when such actions have been advanced by the issuer's use of the attorney's services.

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Sections 205.4 and 205.5 detail the respective responsibilities of supervisory and subordinate attorneys, both those employed in-house by the issuer and those serving as outside counsel retained by the issuer. Collectively, these provisions broadly define who is serving as a supervisory attorney, specifically providing that an individual serving as the CLO of an issuer (or who serves in an equivalent role) is a supervisory attorney under the rule. The provision also places the responsibility for compliance with the rule's reporting requirements and documentation obligations upon the supervisory attorney after he or she has been informed of evidence of a material violation by a subordinate. Subordinate attorneys are not exempt from the rule, though they will have complied with it where they report evidence of material violations they learn about to their supervisory attorney. In addition, a subordinate attorney who has reported evidence of a material violation to a supervisory attorney, and who believes that the supervisory attorney has failed to comply with the reporting requirement under the rule is permitted, but not obligated, to report the evidence ``up the ladder'' within the issuer.

Section 205.6 describes the manner in which violations of the rule will be addressed by the Commission. Violation of the proposed rule will subject the violator to all the remedies and sanctions available under the Exchange Act, including injunctions, and cease and desist orders. An attorney who violates a provision of Part 205 will have engaged in improper professional conduct and may also be subject to administrative disciplinary proceedings that can result in a censure, or a suspension or bar from practicing before the agency. Paragraph 205.6(b) incorporates the same state of mind requirements that were adopted for accountants by the Commission in the 1998 amendment to Rule 102(e). Specifically, an attorney is subject to discipline for (1) intentional, including reckless, violations of the Part, and (2) negligent conduct in the form of a single instance of highly unreasonable conduct that results in a violation, or repeated instances of unreasonable conduct resulting in a violation of the Part. The rule provides that the Commission may impose discipline and sanction an attorney who violates the rule, even when the attorney is subject to discipline in the state where he or she practices or is admitted.

V. Section-by-Section Discussion of the Proposed Rule and Request for Comments

The proposing release invites interested persons to submit comments on a large number of specific issues. However, the Commission invites any interested person to submit comments on any aspect of the proposed rule, whether or not comments have been specifically solicited.

Section 205.1 Purpose and Scope

Section 307 of the Act expressly directs the Commission to adopt a rule imposing a reporting requirement upon attorneys ``appearing and practicing before the Commission in any way in the representation of issuers''. Section 307 mandates that the Commission ``shall issue rules * * * setting forth minimum standards of professional conduct * * * including a rule'' imposing an ``up the ladder'' reporting requirement. At the very least, this language directs the Commission to issue a rule requiring attorneys to report material misconduct within an issuer. The Commission may at some future date supplement or amend this rule to expand its scope and address additional ethical issues that are relevant to practice before the Commission.\29\ Interested persons are invited to comment on whether the Commission should promulgate additional rules, the issues those rules should address, how, in what form, and why.

\29\ The Commission does not propose to create an ``SEC Bar'' with admission requirements, of which attorneys must be members to appear or practice before the Commission. See 5 U.S.C. 500(b) (prohibiting agencies from enacting their own supplemental admission requirements for duly admitted members of a state bar). However, the Commission ``like any other institution in which lawyers or other professionals participate, has authority to police the behavior of practitioners appearing before it.'' Polydoroff v. ICC, 773 F.2d 372, 374 (D.C. Cir. 1985). This authority is confirmed, of course, in the new Section 4C of the Exchange Act and Section 307 of the Sarbanes-Oxley Act.

Section 205.2 Definitions

Proposed Part 205 includes a section defining a number of terms that appear in the statute and are used throughout the rule. Section 307 of the Act does not define any of its terms. The Act itself defines the term ``issuer,'' and that definition is incorporated into the rule. For several of the terms in the rule, the Commission has adopted the definitions contained in the ABA's Model Rules of Professional Conduct or a variation thereof. For others, the Commission has relied upon statutory definitions or adopted definitions from other sources, including the Restatement (Third) of the Law Governing Lawyers.

For those terms in Section 307 that are included in the proposed rule but not specifically defined in the proposed rule (e.g., ``in any way'' and ``similar violations''), the Commission's intention is that their meaning shall be determined or interpreted according to Commission decisions. Interested persons are invited to comment on whether the Commission should leave these or other terms undefined in the rule or, alternatively, to propose definitions for these or other terms.

  (a) Appearing and practicing before the Commission includes, but is not limited to, an attorney's:

  (1) Transacting any business with the Commission, including communication with Commissioners, the Commission, or its staff;

  (2) Representing any party to, or the subject of, or a witness in a Commission administrative proceeding;

  (3) Representing any person in connection with any Commission investigation, inquiry, information request, or subpoena;

  (4) Preparing, or participating in the process of preparing, any statement, opinion, or other writing which the attorney has reason to believe will be filed with or incorporated into any registration statement, notification, application, report, communication or other document filed with or submitted to the Commissioners, the Commission, or its staff; or

  (5) Advising any party that:

  (i) A statement, opinion, or other writing need not or should not be filed with or incorporated into any registration statement, notification, application, report, communication or other document filed with or submitted to the Commissioners, the Commission, or its staff; or

  (ii) The party is not obligated to submit or file a registration statement, notification, application, report, communication or other document with the Commission or its staff.

The definition of the term ``appearing and practicing before'' the Commission is based upon Rule 102(f).\30\ The wording of that definition has been modified to clarify and confirm that (as under existing Rule 102(f)) the term includes, among other things, representation of an issuer during the course of an investigation or inquiry conducted by the Commission and that an attorney appears and practices before the Commission if he or she advises an issuer either (1) that a statement, opinion, or other writing does not need to be filed with or incorporated into any type of submission to the Commission or its staff, or (2) that the issuer is not required to submit or file any registration statement, notification, application, report, communication or

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other document with the Commission or its staff.

\30\ The definition prescribed in Rule 102(f) is unaffected by the proposed rule.

Moreover, the definition of the term has also been drafted to make clear that it covers all communications (oral or written) with the Commission or its staff on behalf of an issuer, as well as conduct involving the preparation of any statement, opinion, or other writing which is submitted to Commissioners, the Commission, or its staff which is incorporated into materials submitted to the Commission--or participation in the process of preparing such a statement, opinion, or other writing. Participation in that process covers both adding and excluding information or a particular characterization of information. The definition also makes clear that an attorney who advises an issuer not to make a filing or submission to the Commission is also appearing and practicing before the Commission.

This broad definition is consistent with the position the Commission has taken as amicus curiae in cases involving liability under Section 10(b) of the Exchange Act (15 U.S.C. 78j(b)) in which the Commission has argued that attorneys should be held responsible for materials which they have drafted, or participated in drafting, that they knew would be included in a document to be filed with the Commission but which have been submitted without attribution or under another individual's signature.\31\ The modification also reflects the reality that materials filed with the Commission frequently contain information contributed, edited or prepared by individuals who are not necessarily responsible for the actual filing of the materials.

\31\ The Commission has taken this position in several important recent cases, including Newby, et al. v. Enron Corp. (C.A. HO-13624) (S.D. Tex) (an ongoing private class action suit in which the Commission has submitted briefs as an amicus curiae) and Klein v. Boyd, 1998 U.S. App. LEXIS 2004 (3rd Cir. Feb. 12, 1998), vacated and reh'g, en banc, granted, 1998 U.S. App. LEXIS 4121 (3rd Cir. Mar. 9, 1998).

An attorney ordinarily does not appear and practice before the Commission if his or her representation of an issuer involves no business or communication with the Commission, no participation in any way in a Commission process, and no assistance in the preparation of at least a portion of a document filed with or submitted to the Commission. The conduct of attorneys in practice specialties other than securities law will be covered by the proposed rule where their representation of an issuer involves contact with the Commission or where they have reason to believe they are assisting in the preparation of a document transmitted to the Commission, or where they supervise an attorney who does appear and practice before the Commission.

The proposed definition of ``appearing and practicing'' is broad enough to include attorneys who do not serve in the legal department of an issuer or do not act in their capacities as attorneys, but who either transact business with the Commission or assist in the preparation of documents filed with or submitted to the Commission.

Interested persons are invited to comment on any aspect of this definition, including its appropriate scope and whether the Commission should exclude any persons from the definition of ``appearing and practicing'' (e.g., in-house corporate attorneys working outside of a legal department who assist in preparing a document to be filed with the Commission). Interested persons are specifically invited to comment on whether, and how, the definition of ``appearing and practicing'' will impact upon attorneys representing issuers during the course of Commission investigations, inquiries, administrative proceedings or civil litigation, and whether and how the definition should be modified in those contexts. Does the definition need to be modified to make clear that an attorney defending an issuer in a civil injunctive action by the Commission in a district court is not appearing and practicing before the Commission, because the issuer is not transacting business with the Commission, even though the defense attorney is in contact with the Commission's staff who are representing the Commission in that litigation? In the event an attorney representing an issuer in an administrative proceeding fails to receive an appropriate response to evidence of a material violation that the attorney has reported, should the attorney's response be governed by the proposed rule or by the Commission's Rules of Practice? Why? Comment is also particularly invited on the breadth of ``participating in the process of preparing'' in paragraph (a)(4) and whether the ``has reason to believe'' standard in that paragraph is too high or too low (e.g., whether an attorney must have actual knowledge or give express consent for a document to be sent to the Commission in order to be appearing and practicing before the Commission).

The concept of ``appearing and practicing'' also raises issues regarding foreign attorneys employed or retained by foreign issuers. Such attorneys may, for example, be involved in the preparation of documents for use in a foreign jurisdiction that might subsequently be used as the basis for other documents prepared by others for filing with the Commission, with or without the knowledge of the foreign attorneys who prepared the original documents. Interested persons are invited to comment on whether such foreign attorneys are ``appearing and practicing'' before the Commission; if not, how the proposed definition might be modified to make that clear; whether an express exclusion for such foreign attorneys is necessary and, if so, how it might be crafted.

  (b) Appropriate response means a response to evidence of a material violation reported to appropriate officers or directors of an issuer that provides a basis for an attorney reasonably to believe:

  (1) That no material violation, as defined in paragraph (i) of this section, is occurring, has occurred, or is about to occur; or

  (2) That the issuer has, as necessary, adopted remedial measures, including appropriate disclosures, and/or imposed sanctions that can be expected to stop any material violation that is occurring, prevent any material violation that has yet to occur, and/or rectify any material violation that has already occurred.

The definition of the term ``appropriate response'' emphasizes that the actions of attorneys in evaluating possible instances of material violations and the appropriateness of the response made by an issuer apprised of possible instances of material violations will be evaluated against an objective reasonableness standard. The Commission's intent is to permit attorneys to exercise their judgment as to whether a response to a report is appropriate, so long as their determination of what is an ``appropriate response'' is objectively reasonable.

For example, if an issuer responds to an attorney's report regarding the legality of a particular transaction by informing the attorney that a reputable law firm has reviewed the transaction and concluded that there has been no violation, and if the issuer provides a copy of the opinion to the attorney, the attorney could reasonably believe that the issuer's response was appropriate so long as the opinion satisfactorily addresses all of the reporting attorney's reasonable legal and factual concerns and is otherwise reasonable. Similarly, if an issuer responds to an attorney's report concerning another employee's potentially illegal conduct by, for example, disciplining or terminating the employee, and remedying any impact of the employee's misconduct, the attorney could reasonably believe that the issuer's response was appropriate. If, however, the issuer responds to the attorney's report by peremptorily

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informing the attorney that the reported matter is not cause for concern, and fails to provide any factual or legal basis for the reporting attorney to conclude there was no violation, such a response may not reasonably be viewed as appropriate by the attorney.

An appropriate response where there has been a disclosure violation would include disclosure of the material information or the correction of any material misstatement. Further, it could include an express directive forbidding the unlawful conduct at issue or, if it has already commenced, ordering that it cease at once. The definition also clarifies that past instances of misconduct may not need to be reported further where that misconduct has been addressed, for example, through the imposition of sanctions or other means. A past instance of misconduct that nevertheless may have an ongoing impact (e.g., a misstatement contained in a prior Commission filing that investors may continue to rely upon) will need to be rectified.

Interested persons are invited to comment on any aspect of what is an appropriate response. Should an attorney's reasonable belief determine whether a response is appropriate? What circumstances would permit an attorney reasonably to believe either that no violation has occurred or that any violation has been rectified? Is there a better objective test to measure whether a response is appropriate and, if so, what is it?

  (c) Attorney refers to any person who is admitted, licensed, or otherwise qualified to practice law in any jurisdiction, domestic or foreign, or who holds himself or herself out as admitted, licensed, or otherwise qualified to practice law.

The term ``attorney'' is defined broadly so that the proposed rule applies equally to lawyers employed in-house by an issuer and attorneys retained to perform legal work on behalf of an issuer, and covers persons who hold themselves out as attorneys, even if they are not in fact admitted, licensed, or otherwise qualified to practice law. Interested persons are invited to comment on the impact this definition will have upon attorneys in particular positions, or performing particular functions, and to identify situations in which the definition may reach too broadly. In particular, the Commission requests comment on whether the definition should require, with respect to in-house counsel, that the attorney actually provide legal services to the issuer such that an attorney-client relationship exists, so as to exclude attorneys employed by issuers in non-legal capacities, even if they prepare portions of documents submitted to or filed with the Commission.

The proposed definition of ``attorney'' also covers lawyers licensed in foreign jurisdictions, whether or not they are also admitted to practice in the United States. Under the proposed definition, foreign attorneys who prepare filings or other materials that are submitted to the Commission would be covered by the rule to the extent they are appearing and practicing before the Commission within the meaning of the rule. Potential difficulties related to applying the term ``appearing and practicing'' to foreign attorneys have been discussed above. The Commission also recognizes that significant issues would be raised by application of the proposed rule to foreign attorneys, or attorneys representing or employed by multijurisdictional firms, who may be subject to statutes, rules, and ethical standards in these foreign jurisdictions that are different from, and potentially incompatible with, the requirements of this rule. As noted above, over 1,300 foreign private issuers from 59 countries are registered and reporting with the Commission. These foreign companies are represented by a wide-range of legal counsel. While U.S. lawyers at U.S. law firms often play the principal role in the preparation of disclosure documents filed with the Commission by foreign companies, foreign lawyers can also undertake significant roles in these filings. For example, foreign counsel is often called upon to file a legal or tax opinion as an exhibit to a registration statement filed by a foreign company. In addition, a number of non-U.S.-based law firms (principally firms based in the United Kingdom) have established significant legal practices under the U.S. federal securities laws, and may be the sole law firms representing a particular issuer before the Commission. Generally, such firms have attorneys who are licensed in the United States. Likewise, many U.S. law firms have expanded globally and now employ as partners, counsel and associates lawyers who are admitted to practice solely in jurisdictions outside the United States. These non-U.S. lawyers may play significant roles in connection with Commission filings by both foreign and U.S. issuers. Further, some non- U.S. registrants have employed U.S. or non-U.S. lawyers to serve as their in-house counsel with respect to federal securities law questions.

As proposed, Part 205 would cover lawyers who are licensed in foreign jurisdictions, although only to the extent they ``appear and practice'' before the Commission in the representation of issuers. The Commission recognizes that the application of Part 205 to foreign law firms, multijurisdictional law firms and foreign lawyers raises significant and difficult issues. Because of these issues, the Commission seeks comment on the application of Part 205 to these entities. In particular:

Are there statutes, rules and ethical standards in foreign jurisdictions that govern the conduct of foreign attorneys that are different from, and potentially incompatible with, the requirements of Part 205 and, if so, what foreign authority conflicts with what specific provisions of Part 205?

Are there provisions in Part 205 that could not be given effect (or would be nullified) under statutes, rules, or ethical standards in some foreign jurisdictions? If so, which provisions are affected, and how would this situation affect implementation of Part 205?

How would the ``up the ladder'' rule apply to in-house and retained attorneys in jurisdictions where issuers use different internal corporate structures not contemplated by Part 205?

What difficulties are likely to arise in applying the QLCC alternative to foreign issuers, and how, specifically, could the QLCC alternative be adapted to foreign private issuers?

What are the difficulties in applying Part 205 to law firms that operate in multiple jurisdictions or that have partners, counsel and associates who are admitted to practice law in a foreign jurisdiction but not admitted to practice law in the United States and who participate in the preparation of documents filed with the Commission (or documents that form the basis for documents filed with the Commission)? Are there different considerations in the application of Part 205 in this circumstance depending on whether the law firm in question is principally based in the United States or outside the United States?

What are the difficulties in applying Part 205 to an issuer's in- house attorneys who are admitted to practice law in a foreign jurisdiction but are not admitted to practice law in the United States and who participate in the preparation of documents filed with the Commission (or documents that form the basis for documents filed with the Commission)? Are there different considerations in the application of Part 205 in this circumstance whether the issuer is incorporated in the United States or in a foreign jurisdiction? Any such special difficulties and considerations should be discussed with specificity.

Are there mechanisms that satisfy the objectives of Part 205 that would apply

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the rule to a narrower category of foreign-licensed attorneys--for example, by employing a variation of the proposed definitions of supervisory and subordinate attorneys or by identifying attorneys in the United States who would have responsibility for compliance with U.S. securities laws? How, specifically, would such mechanisms work?

With respect to disciplinary proceedings, do foreign jurisdictions maintain procedures for disciplining attorneys for violations of statutes, rules or standards relating to ethical conduct and, if so, how do these procedures operate? Is a Commission proceeding against an attorney that violated Part 205 reconcilable with a disciplinary proceeding in the home jurisdiction?

Should foreign attorneys be exempted in whole or in part from the application of Part 205, and if so, why? Are there protections under foreign statutes, rules and standards relating to ethical conduct that serve as an adequate substitute for the various provisions of Part 205? Should the Commission establish a process under which foreign attorneys may apply for exemptions on a case-by-case basis, and if so, what should this process be (for example, the submission of a legal opinion as to the incompatibility of some or all of Part 205 with foreign statutes, rules and standards, and whether those statutes, rules and standards serve as an adequate substitute for the various provisions of Part 205)?

  (d) Breach of fiduciary duty refers to any breach of fiduciary duty recognized at common law, including, but not limited to, misfeasance, nonfeasance, abdication of duty, abuse of trust, and approval of unlawful transactions.

This definition is intended to identify typical common-law breaches of fiduciary duty. It is not intended to change the law.

Interested persons are invited to comment on any aspect of the definition of ``breach of fiduciary duty,'' including whether the examples given should be expanded or narrowed, and, if so, how.

  (e) Evidence of a material violation means information that would lead an attorney reasonably to believe that a material violation has occurred, is occurring, or is about to occur.

This objective standard is intended to preclude reports based on mere suspicion of a material violation while providing reasonable flexibility to attorneys when evaluating their reporting obligations under the proposed rule. An individual attorney is not excused from reporting evidence of a material violation on the grounds that he or she does not personally believe that a material violation has occurred, is occurring, or is about to occur. Under the definition of ``reasonably believes'' in paragraph (l) of Section 205.2, any information that would lead an attorney, acting reasonably, to believe that a material violation has occurred, is occurring, or is about to occur must be reported--whether or not the reporting attorney subjectively believes it. An individual attorney is not, however, required to report within the issuer evidence of a material violation that the attorney thinks is insufficient to lead an attorney, acting reasonably, to believe that a material violation has occurred, is occurring, or is about to occur. The definition does not prescribe a process by which an attorney must evaluate evidence he or she learns about.

Interested persons are invited to comment on any aspect of the definition of ``evidence of a material violation.'' Should a different standard be adopted than that proposed by the Commission and, if so, what should that different standard be? Should the test be subjective rather than objective? Where along the spectrum from actual knowledge to mere suspicion should the line be drawn? Is the correct measure ``beyond a reasonable doubt,'' ``knows or should know,'' ``substantial credible information,'' a ``prima facie case,'' ``more likely than not,'' ``at least as likely as not,'' ``reason to believe,'' ``some credible information,'' ``a mere scintilla of information sufficient to raise suspicion,'' or another test and, if so, what? If reasonable belief is the appropriate standard, what should be reasonably believed: that a material violation has occurred, is occurring, or is about to occur or that a material violation may have occurred, may be occurring, or may be about to occur, or something else? Should the definition be revised to make clearer that the standard is objective rather than subjective and, if so, how?

  (f) In the representation of an issuer means acting in any way on behalf, at the behest, or for the benefit of an issuer, whether or not employed or retained by the issuer.

The proposed rule includes a broad definition of what constitutes ``in the representation of an issuer.'' A broad definition is essential to protect investors. Accordingly, the term is defined to cover attorneys providing any legal services at the request of, or for the benefit of, an issuer.

For example, an attorney employed or retained by a non-public subsidiary of a public parent issuer is appearing and practicing before the Commission in the representation of an issuer when the subsidiary is covered by an umbrella representation agreement or understanding, whether explicit or implicit, under which the attorney represents the parent company and its subsidiaries, and can invoke privilege claims with respect to all communications involving the parent and its subsidiaries. Similarly, an attorney at a non-public subsidiary appears and practices before the Commission in the representation of an issuer when he or she is assigned work by the parent (e.g., preparation of a portion of a disclosure document) which will be consolidated into material submitted to the Commission by the parent, or if he or she is performing work at the direction of the parent and discovers evidence of misconduct which is material to the parent. The definition of the term is also intended to reflect the duty of an attorney retained by an issuer to report to the issuer evidence of misconduct by an agent of the issuer (e.g., an underwriter) if the misconduct would have a material impact upon the issuer.

An attorney employed by a privately-held investment adviser who prepares, or assists in preparing, materials that the attorney has reason to believe will be submitted to or filed with the Commission by or on behalf of a registered investment company, or will be incorporated into any document filed with or submitted to the Commission, is appearing and practicing before the Commission. Such an attorney, though employed by a privately-held investment adviser, is representing the investment company before the Commission. Where such an attorney discovers evidence of a material violation by an officer of the investment adviser that is related to the investment company, the attorney is obliged to report that evidence to the CLO of the investment company under 205.3(b). The investment adviser is an agent of the investment company and owes the investment company a fiduciary duty under common law and under Section 36 of the Investment Company Act of 1940.\32\ Section 307 of the Act requires an attorney to report evidence of a material violation by any agent of an issuer to the issuer's CLO or CEO.

\32\ 15 U.S.C. 80a-35.

This reporting obligation does no violence to the attorney-client privilege. Because the attorney is providing legal services for the registered investment company, the attorney is reporting to his or her client evidence of a material violation that is related to his or her

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representation of the client.\33\ In effect, an attorney employed by the investment adviser and representing the investment company before the Commission has joint clients. Fairness and candor between co- clients regarding matters of common interest normally preclude any expectation of confidentiality regarding communications with their attorney, even regarding a communication of which one co-client was unaware at the time it was made.\34\ That analysis must apply with special force where the co-clients are both organizations, with the investment adviser owing a fiduciary duty to the investment company, and where the attorney employed by the investment adviser, like any attorney employed by an organization, represents the investment adviser as an organization, not officers or employees who may have engaged in misconduct injuring the investment company.

\33\ See Restatement (Third) of the Law Governing Lawyers, section 14 and Comment c (``a client-lawyer relationship results when legal services are provided''), and Virginia Supreme Court Rule 6:1-1(B) (``Generally, the relation of attorney and client exists, and one is deemed to be practicing law whenever he furnishes to another advice or service under circumstances which imply his possession and use of legal knowledge or skill.''). See also 205.3(d)(2) (permitting an attorney appearing and practicing before the Commission in any way in the representation of an issuer to disclose client confidences to the Commission under specified circumstances).

\34\ See Restatement (Third) of the Law Governing Lawyers, section 75 and Comment d (explaining that in a subsequent proceeding in which the co-clients' interests are adverse there is normally no attorney-client privilege regarding either co-client's communications with their attorney during the co-client relationship).

Interested persons are invited to comment on the appropriate scope of the term, and its impact upon attorneys. Does the definition provide sufficient clarity and, if not, how could it be improved? Are there factual circumstances the definition would bring in that might better be excluded? Does the definition go far enough to protect investors?

  (g) Issuer means an issuer (as defined in Section 3 of the Securities Exchange Act of 1934 (15 U.S.C. 78c)), the securities of which are registered under Section 12 of that Act (15 U.S.C. 78l), or that is required to file reports under Section 15(d) of that Act (15 U.S.C. 78o(d)), or that files or has filed a registration statement that has not yet become effective under the Securities Act of 1933 (15 U.S.C. 77a et seq.), and that it has not withdrawn.

The definition for the term ``issuer'' adopts the definition set forth in Section 2(a)(7) of the Act, which in turn incorporates the definition contained in the Exchange Act. This definition raises a question regarding whether the rule should also apply to attorneys who represent various entities that are subject to comprehensive Commission regulation and oversight, and who regularly appear before the agency, but whose clients are not ``issuers.'' For example, many broker- dealers, investment advisers, self-regulatory organizations, transfer and clearing agents are, by law, required to register with the Commission. Attorneys for these entities prepare documents that are filed with the Commission and interact regularly with the Commission. As a regulated entity that is not an issuer presumably does not have a board of directors or an audit committee, and perhaps not even a chief legal officer, imposing the proposed rule on such entities may be inappropriate.

Certain foreign governments have listed debt securities that are registered under Section 12(b) of the Exchange Act. These foreign governments are thus issuers under the Act's definition. These foreign governments, however, may not have the organizational structure contemplated by the proposed rule in that the foreign governments may not have reasonable equivalents to a CEO, an audit committee, independent directors, or a board of directors. Thus, it may be difficult or inappropriate to apply the new Part 205 to such foreign issuers. It may be necessary for the Commission to create an exception or exemption for foreign governments that are issuers of listed debt securities.

The Commission invites interested persons to comment on any aspect of this definition, including: whether some form of ``up the ladder'' reporting should be implemented for attorneys employed by regulated entities that are not issuers; whether there is good reason or a legal basis to alter the definition in Section 2(7) of the Act; and whether the Commission should create an exemption for foreign issuers-- providing, for example, that ``Part 205 shall not apply to foreign governments that are eligible to register [or ``that register''] securities under Schedule B of the Securities Act of 1933''--or should modify the definition of ``issuer'' to exclude foreign issuers--and, if so, how.

  (h) Material refers to conduct or information about which a reasonable investor would want to be informed before making an investment decision.

The definition for the term ``material'' is derived from Supreme Court precedent, and is consistent with the remarks of Senator John Edwards, the sponsor of Section 307, who stated that ``the obligation to report is triggered only by violations that are material--violations that a reasonable investor would want to know about.''\35\

\35\ See 148 Cong. Rec. at S6552 (July 10, 2002). See also TSC Indus. v. Northway, Inc., 426 U.S. 438 (1976); Basic, Inc. v. Levinson, 485 U.S. 224 (1988); Staff Accounting Bulletin 99, 99 WL 1123037.

Interested persons are invited to comment on this definition, particularly whether it provides sufficient clarity or, alternatively, whether another formulation would be preferable.

  (i) Material violation means a material violation of the securities laws, a material breach of fiduciary duty, or a similar material violation.

The rule defines the term ``material violation'' to clarify that the term ``material'' in Section 307(b) modifies all three succeeding references to violations (i.e., ``violation of securities law,'' ``breach of fiduciary duty,'' and ``similar violation''), and that only evidence of material misconduct triggers the rule's reporting obligation.

The rule does not define what constitutes a ``violation of securities law'' since the term is well-understood. The Commission believes that the term covers violations of the federal securities laws, as defined in Section 2(a)(15) of the Act, as well as violations of state securities laws. The rule separately defines ``breach of fiduciary duty'' to cover those forms of breach of fiduciary duty recognized at common law, including misfeasance, nonfeasance, abdication of duty, abuse of trust and the approval of unlawful transactions.

The rule does not define the term ``similar violation.'' However, it appears from the context in which it is used in Section 307 that the term is intended to extend beyond a breach of fiduciary duty or a violation of the securities laws.

Interested persons are invited to comment on any aspect of the definition. Is there good reason to exempt violations of state securities laws from the definition? Should the term ``similar violation'' be defined and, if so, how? Does the definition encompass conduct about which the Commission should not be concerned? Would an alternate test be better? What test, and why?

  (j) Qualified legal compliance committee means a committee of an issuer that:

  (1) Consists of at least one member of the issuer's audit committee and two or more members of the issuer's board of directors who are not employed, directly or indirectly, by the issuer and who are not, in the case of a registered investment company, ``interested persons'' as defined in Section 2(a)(19) of the Investment Company Act of 1940 (15 U.S.C. 80a-2(a)(19));

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  (2) Has been duly established by the issuer's board of directors and authorized to investigate any report of evidence of a material violation by the issuer, its officers, directors, employees or agents;

  (3) Has established written procedures for the confidential receipt, retention, and consideration of any report of evidence of a material violation under Sec. 205.3(c);

  (4) Has the authority and responsibility:

  (i) To inform the issuer's chief legal officer and chief executive officer (or the equivalents thereof) of any report of evidence of a material violation (except in the circumstances described in Sec. 205.3(b)(5));

  (ii) To decide whether an investigation is necessary to determine whether the material violation described in the report has occurred, is occurring, or is about to occur and, if so, to:

  (A) Notify the audit committee or the full board of directors;

  (B) Initiate an investigation, which may be conducted either by the chief legal officer (or the equivalent thereof) or by outside attorneys; and

  (C) Retain such additional expert personnel as the committee deems necessary; and

  (iii) At the conclusion of any such investigation under paragraph (j)(4)(ii) of this section, to:

  (A) Direct the issuer to adopt appropriate remedial measures, including appropriate disclosures, and/or to impose appropriate sanctions to stop any material violation that is occurring, prevent any material violation that is about to occur, and/or to rectify any material violation that has already occurred; and

  (B) Inform the chief legal officer and the chief executive officer (or the equivalents thereof) and the board of directors of the results of any such investigation under paragraph (j)(4)(ii) of this section and the appropriate remedial measures to be adopted; and

  (5) Each member of which individually, together with the issuer's chief legal officer and chief executive officer (or the equivalents thereof) individually, has the authority and responsibility, in the event the issuer fails in any material respect to take any of the remedial measures that the qualified legal compliance committee has directed the issuer to take, to notify the Commission that a material violation has occurred, is occurring or is about to occur and to disaffirm in writing any document submitted to or filed with the Commission by the issuer that the individual member of the qualified legal compliance committee or the chief legal officer or the chief executive officer reasonably believes is false or materially misleading.

A ``qualified legal compliance committee'' (``QLCC''), as here defined, is part of an alternative procedure for reporting evidence of a material violation. That alternative procedure is set out in Section 205.3(c) of the proposed rule and is discussed below. Excluding ``interested persons'' of a registered investment company from the investment company's QLCC is intended to ensure that the members of such a QLCC will be truly independent, as explained further in the discussion of Section 205.3(b)(4) below.

Interested persons are invited to comment on any aspect of the definition of a QLCC, considered in light of Section 205.3(c), specifically including whether any changes should be made to the definition, either in light of Section 205.3(c) as proposed or in light of changes that the interested persons believe should be made to that section. Should the written procedures for the retention of reports, which a QLCC must establish pursuant to paragraph 205.2(j)(3), require the QLCC to retain paper or electronic copies of all reports submitted by attorneys? Should this requirement be expanded to obligate the QLCC to retain paper or electronic copies of responses to attorney reports?

  (k) Reasonable or reasonably denotes the conduct of a reasonably prudent and competent attorney.

The definition of ``reasonable'' or ``reasonably'' is taken from Rule 1.0(h) of the ABA's Model Rules of Professional Conduct. Interested persons are invited to comment on whether this definition is sufficiently clear and whether alternative language would be an improvement.

  (l) Reasonably believes means that an attorney, acting reasonably, would believe the matter in question.

This definition is based on the definition of ``reasonable belief'' or ``reasonably believes'' in Rule 1.0(i) of the ABA's Model Rules of Professional Conduct, modified to eliminate any implied subjective element. It is intended to define when belief is objectively reasonable. Interested persons are invited to comment on whether this definition is sufficiently clear and whether alternative language would be an improvement and, if so, what alternative language interested persons would propose. Would the definition of ``reasonable belief'' by New Jersey's Supreme Court, for example, be clearer: ``Reasonable belief for purposes of R[ule of ]P[rofessional] C[onduct] 1.6 is the belief or conclusion of a reasonable lawyer that is based upon information that has some foundation in fact and constitutes prima facie evidence of the matters referred to in paragraphs (b) or (c)''?

  (m) Report means to make known to directly, either in person, by telephone, by e-mail, electronically, or in writing.

This definition emphasizes that an attorney who is obligated to report evidence of a material violation must do so directly rather than indirectly. Although the attorney is not required to communicate in person with the appropriate individual, the Commission believes that it is essential for any report to be made directly rather than through a third party to ensure clarity. In light of the report's importance, most attorneys would want to report directly in any event.

Interested persons are invited to comment on any aspect of this definition. Should the attorney be required to make a written report, or to memorialize the substance of the report in writing shortly after making it? Should the attorney be required to keep a record of the report, including all supporting documentation? Should the Commission require that the report be made in person? Should the Commission prescribe a format for the report? Should the Commission require that a witness be present for each report? Should an attorney be permitted to delegate his or her reporting requirement to another and, if so, under what circumstances?

Section 205.3 Issuer as Client

Section 205.3 is at the core of the Commission's proposed ``Standards of Professional Conduct for Attorneys.'' It sets out the rule on reporting ``evidence of a material violation of securities law or breach of fiduciary duty or similar violation by the company or any agent thereof,'' as required by the Act. It also sets out related provisions addressing an attorney's obligations to the issuer. Representing an Issuer

Section 205.3(a) provides:

  (a) Representing an issuer. An attorney appearing and practicing before the Commission in the representation of an issuer represents the issuer as an organization and shall act in the best interest of the issuer and its shareholders. That the attorney may work with and advise the issuer's officers, directors, or employees in the course of representing the issuer does not make such individuals the attorney's clients.

This paragraph of the proposed rule makes explicit that the client of an attorney representing an issuer before the Commission, in any way, is the issuer as an entity, not the issuer's individual officers or employees that the attorney regularly interacts with and advises on the issuer's behalf. Those officers and other employees, like the attorney, have a fiduciary duty to act in the best interests of the issuer and its shareholders.

This paragraph is grounded in a lawyer's well-established duty to act with reasonable competence and diligence in representing a client and to take steps to prevent reasonably foreseeable harm to the client--

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including harm from persons who work for the client.\36\ As the Cheek Report explains (at 27), the premise of the ABA's equivalent rule (Model Rule 1.13) is that, when a lawyer represents an organization (such as an issuer),

\36\ See, e.g., Restatement (Third) of the Law Governing Lawyers (2000) section 96; Model Rules 1.1 and 1.2; FDIC v. O'Melveny & Myers, 61 F.3d 17, 19 (9th Cir. 1995) (incorporating verbatim the applicable section of its earlier opinion); FDIC v. O'Melveny & Myers, 969 F.2d 744, 748-49 (9th Cir. 1992), rev'd on other grounds, 512 U.S. 79 (1994).

the organization is the lawyer's client and * * * the lawyer owes that client an obligation of protection from harm. Harm can result when an officer breaches a duty to the corporation (e.g. wastes or misappropriates corporate assets), when the corporation will be caused to injure a third party who will then have a claim against the corporation or when the corporation will be exposed to a fine or penalty. In any such case the lawyer's duty to protect the corporate client from harm requires the lawyer to serve the interest of the corporation and its shareholders rather than the interests of the

individual officers or employees who are acting for the corporation.

The attorney representing an issuer does not represent the issuer's officers and employees simply because the attorney necessarily interacts with them in representing the issuer, and the attorney should make that clear to those officers and employees. Any attorney-client privilege for information related to the issuer's affairs that the officers and employees communicate to the attorney belongs to the issuer.\37\

\37\ See, e.g., United States v. Int'l Bhd. of Teamsters, Chauffeurs, Warehousemen & Helpers of America, AFL-CIO, 119 F.3d 210, 215-17 (2d Cir. 1997).

Interested persons are invited to comment on any aspect of this paragraph, including whether it should be expanded to address under what circumstances an attorney for the issuer may also represent officers, directors and employees, and, if an attorney does so, the related questions of: (1) The responsibilities of an attorney when there is a potential for a conflict of interest; (2) obtaining waivers from clients when there is a conflict of interest; and (3) terminating representation when an actual conflict arises. Reporting Within the Issuer Evidence of a Material Violation

Section 205.3(b) of the proposed rule clarifies and codifies an attorney's duty to protect the interests of the issuer the attorney represents by reporting within the issuer evidence of a material violation by any officer, director, employee, or agent of the issuer.

Paragraph (b)(1) provides:

  (b) Duty to report evidence of a material violation. (1) If, in appearing and practicing before the Commission in the representation of an issuer, an attorney 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 any evidence of a material violation to the issuer's chief legal officer (or the equivalent thereof) or to both the issuer's chief legal officer and its chief executive officer (or to the equivalents thereof) forthwith (unless the issuer has a qualified legal compliance committee and the attorney chooses instead to report the evidence of a material violation to that committee under paragraph (c) of this section). An attorney does not reveal client confidences or secrets by communicating information related to the attorney's representation of an issuer to the issuer's officers or directors.

Paragraph (b)(1) describes the first step that an attorney representing an issuer is required to take after he or she becomes aware of information that would lead an attorney reasonably to believe that a material violation by an issuer or by any of the issuer's officers, directors, employees, or agents has occurred, is occurring, or is about to occur (unless the issuer has a qualified legal compliance committee, and the attorney chooses to report to it).\38\ In utilizing this standard, the rule seeks to balance the likelihood of increased compliance with the law as a result of having an appropriate triggering standard that prompts the bringing of potentially illegal conduct to the attention of the issuer's management against the likelihood of decreased compliance resulting from reduced consultation with an issuer's attorneys through adoption of too high a standard.

\38\ This appears to have been the expectation of the Senators who drafted Section 307 of the Act. See 148 Cong. Rec. S6552 (July 10, 2002) (statement of Sen. Edwards) (``the SEC shall make one rule in particular, and it is a simple rule with two parts. No. 1, a lawyer with evidence of a material violation has to report that evidence either to the chief legal counsel or the chief executive officer of the company. No. 2, if the person to whom that lawyer reports doesn't respond appropriately by remedying the violation, by doing something that makes sure it is cured, that lawyer has an obligation to go to the audit committee or to the board. It is that simple. * * * If the CEO can do a short investigation, for example, and figure out that no violation occurred, then the obligation stops there. But if there is a serious violation of the law, the appropriate response is clear: The CEO has to act promptly to remedy the violation. If he doesn't, the lawyer has to go to the board. It is that simple.'' ). Accord id. at S6555 (statement of Sen. Enzi) (``This amendment instructs the Commission to establish rules that require an attorney, with evidence of material legal violation by the corporation or its agent, to notify the chief legal counsel or the chief executive officer of such evidence and the appropriate response to correct it. If these officers do not promptly take action in response, the Commission is instructed to establish a rule that the attorney then has a duty to take further appropriate action, including notifying the audit committee of the board of directors or the board of directors themselves, of such evidence and the actions of the attorney and others regarding this evidence.''), S6556 (statement of Sen. Corzine) (``when lawyers are aware of a potential violation, they do have a duty to investigate. And if they determine there is a material violation of law--not some small violation, some insignificant rule--that violation should be remedied by the corporation. If it is not remedied, it is the duty of the lawyer, under our language, to report it to the board.'').

As paragraph (b)(1) itself expressly states, an attorney does not reveal client confidences or secrets (or breach the attorney-client privilege) by communicating to the issuer's officers or directors information related to the attorney's representation of the issuer. This legal principle is not controversial.\39\ The Cheek Report, however, recommends incorporating into the ABA's Model Rule 1.13 a clear statement that Model Rule 1.6 does not prohibit communicating client confidences or secrets ``to higher authority within the corporation.'' \40\ The consensus of the Cheek Task Force was that the existing language of Model Rule 1.13(b) ``tends to discourage action by the lawyer to prevent or rectify corporate misconduct'' generally and to ``discourage[] a lawyer from seeking review by higher corporate authority,'' even though the lawyer's goal ought to be to ``minimiz[e] harm resulting from the misconduct.'' Id. The Commission has incorporated such an explicit statement of the legal principle into paragraph (b)(1) of this section.

\39\ Information related to the issuer's affairs communicated to the attorney is effectively communicated to the issuer. The officer or employee thus cannot have any reasonable expectation of confidentiality against the issuer regarding such information, and the attorney breaches no confidence in communicating the information to the issuer's CLO, CEO, or directors. See, e.g., Int'l Bhd. of Teamsters, 119 F.3d at 215-17.

\40\ Id. at 28 (original emphasis). The Cheek Report is available at http://www.abanet.org/buslaw/corporateresponsibility/preliminary_report.pdf. It reflects the consensus of the task force appointed by the ABA's President in March 2002 to re-examine ``the framework of laws and regulations and ethical principles governing the roles of lawyers, executive officers, directors, and other key participants'' so that the ABA could contribute to legislative and regulatory reform aimed at improving corporate responsibility after the Enron bankruptcy; as the report notes, however, not every member of the task force endorses every recommendation. Cheek Report at 1- 2. The Cheek Report recommends amending Model Rules 1.2, 1.6, 1.13, 1.16, and 4.1, especially Rules 1.6 and 1.13. Id. at 27-33, 45-46.

The report required in Section 205.3(b) to prevent or minimize the harm to an issuer resulting from a material violation is internal. It involves no disclosure of confidential information outside the issuer.\41\ The

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report, moreover, is intended to prevent, if possible, misconduct that would injure the issuer and its shareholders, or at least to limit the injury. Accordingly, awareness of information leading an attorney reasonably to believe that a material violation has occurred, is occurring, or is about to occur appears to be the appropriate trigger for the obligation to make an internal report of the evidence of a material violation.

\41\ See also discussion, above, of disclosure to the CLO, CEO, or directors of a registered investment company regarding misconduct by officers or employees of its investment adviser under Section 205.2(f).

As the reporter for the ABA's Commission of Evaluation of Professional Standards (``Kutak Commission'') wrote in 1984, explaining why he considered the ABA's present Model Rule 1.6 (on disclosure of confidential information to outsiders) inadequate,

there is an unavoidable tension between the proposition that the lawyer should act early, to prevent the fraud, and the requirement that he should act only on the basis of solid information. The longer the wait, the more solid the information, but also the greater the likelihood of the client's deeper inculpation.\42\

\42\ Geoffrey C. Hazard, Jr., Rectification of Client Fraud: Death and Revival of a Professional Norm, 33 Emory L.J. 271, 286 (1984).

Requiring more than ``a reasonable basis'' for believing that a client intends to commit, or has committed, fraud before allowing the lawyer to reveal confidential client information to outsiders ``would virtually preclude the possibility of the lawyer's action except in most egregious situations.'' Id. at 285-86. That analysis would appear to apply with even greater force where the disclosure is within an issuer, as required by Section 205.3(b).

Proposed Section 205.3(b) would require an attorney representing an issuer to report within the issuer evidence of ``a material violation by the issuer or by any officer, director, employee, or agent of the issuer.'' The internal report of evidence of a material violation is not comparable to a judicial determination that a material violation actually occurred. There must, however, be some factual basis that would lead an attorney to reasonably believe that a material violation has occurred, is occurring, or is about to occur. The internal report then allows responsible officers of an issuer to consider the reported evidence, investigate where appropriate, and take actions necessary to prevent or minimize any threatened harm to the issuer.\43\

\43\ Senator Edwards foresaw that a CEO to whom the evidence was reported might ``do a short investigation, for example, and figure out that no violation occurred.'' 148 Cong. Rec. S6552 (July 10, 2002).

The ABA's Model Rule 1.13 includes a similar but narrower reporting requirement for attorneys representing an organization, applicable only when the attorney knows that a violation is occurring or going to occur that is likely to result in substantial injury to the organization:

If a lawyer for an organization knows that an officer, employee or other person associated with the organization is engaged in action, intends to act or refuses to act in a matter related to the representation that is a violation of a legal obligation to the organization, or a violation of law which reasonably might be imputed to the organization, and is likely to result in substantial injury to the organization, the lawyer shall proceed as is reasonably necessary in the best interest of the organization.

Even though a securities lawyer ``may be taken as knowing what an alert lawyer would know upon looking with a professional eye at the totality of circumstances there to be seen,'' \44\ the ABA's Model Rule appears to set too high a standard for reporting within an issuer evidence of a material violation, both in requiring an attorney to know that an officer, employee or other person associated with the issuer organization is engaged in or intends a material violation and in requiring that material violation to result in substantial injury to the issuer. Such a high threshold for internal reporting would be inconsistent with Section 307's emphasis on the public interest and protecting investors.

\44\ Hazard, Rectification of Client Fraud, 33 Emory L.J. at 283 (citing cases). See also Cheek Report at 33-35.

The proposed rule obligates an attorney to report information he or she has become aware of that would lead an attorney, acting reasonably, to believe that a material violation has occurred, is occurring or is about to occur. In the Commission's decision in Carter and Johnson and the order entered in Keating, Muething & Klekamp, the Commission addressed the responsibilities of an attorney who ``knows'' of a violation of law by the issuer or its officers. Because those cases dealt with situations where the attorneys knew, or should have known, about their client's misconduct, the Commission's discussion in both cases focused upon an attorney's obligation in that situation. Neither case, however, established actual knowledge of a client's misconduct as a minimum threshold for triggering an attorney's duty to report such misconduct. A rule which obligates an attorney to report only a material violation of which he or she ``knows'' could be interpreted as imposing an initial investigative obligation upon the attorney which he or she may be poorly situated to perform, and which section 307 indicates should be borne by appropriate personnel within the issuer after an attorney has made a report.

When an attorney ``becomes aware'' of information that would lead an attorney reasonably to believe in the existence of a material violation would turn, at least in part, on the attorney's training, experience, position and seniority. Attorneys are not necessarily expected to identify issues they are not equipped to see. What the reasonable, experienced securities lawyer might regard as a clear violation of the law may appear different--or not appear at all--to an unseasoned attorney with a different level of expertise.\45\

\45\ See letter from SIA Ad Hoc Committee to Securities and Exchange Commission, dated Oct. 22, 2002.

The evidence of a material violation that an attorney first becomes aware of may be the tip of an iceberg and, may, on its face, appear unlikely to result in substantial injury to the issuer. For example, evidence indicating that an issuer controls one or two of many special- purpose entities, which individually do not qualify for the off- balance-sheet treatment they have been given, might indicate a material misstatement in the issuer's financial statements, and a material violation of securities law, but not, without more, a material violation likely to result in substantial injury to the issuer.\46\

\46\ The massive fraud perpetrated by O.P.M. Leasing Services, Inc. in the 1970s and early 1980s unraveled after an attorney noticed that payments for computers leased from O.P.M. by one of O.P.M.''s largest customers were being paid directly to O.P.M., even though the lease agreement called for the payments to be made to the lender that was providing financing. Investigation over several months turned up no documentation for two of the many leases at issue. Copies of the missing documentation supplied by the lender revealed that O.P.M. had fabricated the leases and related title documents. O.P.M. had arranged to have the customer's relatively small payments channeled through O.P.M. so that O.P.M. could use its own funds to make the inflated payments due to the lender on the fabricated leases. See Report of the Trustee Concerning Fraud and Other Misconduct in the Management of the Affairs of the Debtor at 24-26, In re O.P.M. Leasing Services, Inc., Reorg. No. 81-B-10533, (Bankr. S.D.N.Y., filed April 25, 1983). Clearly, even two fabricated leases were qualitatively material. However, they were arguably unlikely, by themselves, to result in substantial injury to O.P.M.

The proposed rule, however, is not intended to impose upon an attorney, whether employed or retained by the issuer, a duty to investigate evidence of a material violation or to determine whether in fact there is a material violation. Of course, nothing in the proposed rule is intended to discourage any such inquiry. On the other hand,

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the attorney cannot ignore evidence of a material violation of which he or she is aware.

In proposing this rule, the Commission does not intend to inhibit the consultative process between an issuer and its attorney. The duty to report ``up the ladder'' under section 205.3(b)(2) does not arise from a consultation in which an attorney advises an officer or employee of an issuer that the law regarding a proposed course of action is unsettled and there is some possibility that a court might hold in the future that the action violated the securities laws. Nor does it arise where an officer actually pursues a course of action despite being advised by the attorney that the course of action has been held illegal by courts in three states, in none of which the issuer does business, even if the attorney thinks there is a reasonable argument that other courts would also be likely to find it illegal. The course of action is not clearly illegal, because its legality has not been addressed by courts in any state where the issuer does business. The duty to report does not even arise where the officer tells the attorney that he or she intends to pursue a course of action that the attorney thinks is clearly illegal where the issuer does business, because the officer might reconsider and not do what he or she said he or she would do. The attorney's reporting obligation is not triggered until the attorney can be sure that the officer or employee will actually pursue an illegal course of action.

Interested persons are invited to comm