THE REVISED ROLE OF LAWYERS AFTER SARBANES-OXLEY

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1 THE REVISED ROLE OF LAWYERS AFTER SARBANES-OXLEY CULLEN M. GODFREY Jackson Walker L.L.P. 100 Congress Avenue Suite 1100 Austin, Texas State Bar of Texas 4 TH ANNUAL ADVANCED IN-HOUSE COUNSEL COURSE October 17-18, 2005 San Antonio CHAPTER 18

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5 TABLE OF CONTENTS I. INTRODUCTION... 1 II. ENFORCEMENT ACTIONS AGAINST GENERAL COUNSEL... 2 III. STATE STANDARDS... 4 IV. SARBANES-OXLEY RULES... 6 V. NOISY WITHDRAWAL VI. WHISTLEBLOWER PROTECTION VII. AN ATTORNEY S DUTY TO WITHDRAW i

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7 THE REVISED ROLE OF LAWYERS AFTER SARBANES-OXLEY Sarbanes-Oxley Act of 2002 (H. R. 3763) 1 Sec Rules of Professional Responsibility for Attorneys Not later than 180 days after the date of enactment of this Act, the Commission shall issue rules, in the public interest and for the protection of investors, setting forth minimum standards for 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. I. INTRODUCTION With the foregoing language, Congress, for the first time in the history of the United States, imposed specific professional responsibilities on attorneys who practice before the Securities and Exchange Commission (SEC), and mandated that the SEC issue rules of professional conduct for such attorneys. Proposed rules were published in November 2002, 2 and final rules were adopted on January 23, Though short, Section 307, immediately provoked significant debate, first because of its first time ever statutory federal regulation of attorneys, and second, because many believe it has imposed new and stronger obligations on attorneys representing the organization as client. Section 307 is a departure from the traditional method of regulating attorneys professional responsibility through state authorities 1 The SEC has long had regulations for those who represented clients before it, 4 but these spoke to specific conduct before the Commission. Rule 2(e) provides that: The Commission may censure a person or deny, temporarily or permanently, the privilege of appearing or practicing before it in any way to any person who is found by the Commission after notice and opportunity for hearing in the matter: (i) Not to possess the requisite qualifications to represent others; or (ii) To be lacking in character or integrity or to have engaged in unethical or improper professional conduct; or (iii) To have willfully violated, or willfully aided and abetted the violation of any provision of the Federal securities laws or the rules and regulations thereunder. The Congressional mandate has taken the SEC in a new direction with respect to its responsibility to evaluate attorney conduct. Given long-standing rules governing confidentiality and the attorney-client privilege, one area of obvious importance is any requirement to provide evidence of an attorney s conduct inside the organization. SEC Chairman Harvey Pitt signaled potential SEC analysis in the rulemaking process when he spoke at the American Bar Association s Annual Meeting in Washington, D.C. in Chairman Pitt first acknowledged the rationale for the attorney-client privilege, namely, the willingness of clients to confide in their lawyers, and... to receive the benefits that flow from an unfettered lawyer-client dialogue. He then said: [T]he merits of that concern, if any, apply to individual representations, not the representation of public companies. Lawyers for public companies represent the company as a whole and its shareholder-owners, not the managers who hire and fire them. 5 (emphasis is added) Fortunately, the final rules have not proven to be as draconian as was first feared, but recent events have confirmed that the SEC still sees a major role for lawyers as gatekeepers. In a speech given on September 20, 2004, Stephen Cutler, the SEC s Director of Enforcement, described lawyers who advise companies on disclosure standards and their securities law requirements as being a part of the sentries of the marketplace, 6 and a mere three days later an in-house lawyer was issued a $50, civil penalty for failing to live up to the SEC s expectations. The Sarbanes-Oxley Act of 2002 ( SOX ) was a response to a series of perceived corporate scandals, most notably the collapse of Enron and WorldCom, but including several others. Higher standards were expected

8 of corporate offices, including general counsel, and the SEC was emboldened to enforce these higher standards based on this newly granted authority. The SEC was not limited to SOX, however, and it also heightened the level of enforcement of existing statutes and regulations. In the same speech by Stephen Cutler, noted above, he said that the SEC had named 30 lawyers as respondents or defendants in SEC enforcement actions, and half of those were in-house counsel. II. ENFORCEMENT ACTIONS AGAINST GENERAL COUNSEL John Isselmann, Jr., General Counsel, Electro Scientific Industries, Inc. On September 23, 2004, John Isselmann, Jr., consented to a Cease and Desist Order from the SEC and agreed to pay a $50,000 civil penalty for failing to fulfill his obligations as gatekeeper while serving as General Counsel of Electro Scientific Industries, Inc. (ESI). Isselmann neither admitted nor denied the Order s findings. According to the SEC s Order, 7 Isselmann caused ESI to violate Section 13(a) or the Securities Exchange Act of 1934 and Rules 12b-20 and 13a-13 thereunder by failing to provide important information to ESI s Audit Committee, Board of Directors, and auditors regarding a significant accounting transaction that enabled ESI to report a profit rather than a loss for its quarter ended August 31, The facts were that ESI s Chief financial Officer and it Controller elected to terminate a retirement plan for the company s employees in Asia and reverse an accrual for future pension benefits. By reversing the accrual, ESI was able to report positive net income for the quarter. The CFO directed Isselmann to get a Japanese legal opinion about the termination without telling Isselmann that the accrual reversal had already occurred. When the Japanese opinion was received, it indicated that the pension benefits could not be eliminated unilaterally, and Isselmann so advised the CFO. Subsequently, Isselmann tried to raise the point at a disclosure meeting with ESI s auditors prior to filing the company s quarterly financial statement, but he was cut off by the CFO. Five months after the foregoing events occurred, the CFO had been promoted to Chief Executive Officer, and the new CFO told Isselmann for the first time exactly what had occurred with regard to the earlier accrual reversal. Isselmann immediately advised ESI s Audit Committee and outside counsel, but the SEC concluded that his actions were too little- too late. While there are no allegations that Isselmann in any way participated in the scheme to falsify ESI s financials, the SEC found that Isselmann s failure to disclose the Japanese legal opinion to the Audit Committee, the Board of Directors 2 and outside auditors allowed the CFO and Controller to hide an ongoing fraud. According to Corporate Counsel magazine 8, Isselmann didn t realize he had done anything wrong. He was eight years out of law school with no accounting background and only limited securities experience, and he was the company s only in-house lawyer. He said he thought he was dealing with an employment matter, not an accounting issue. He described himself as a generalist whose job was a mile wide and an inch deep. I relied heavily on accounting people like [the CFO] and outside auditors to flag those issued for me. I didn t have the luxury of focusing on a single and thinking about it for weeks and weeks. He says he only spent an hour and one-half total on the benefits matter. For their part the CFO and Controller have been indicted on 17 counts of financial fraud and falsifying records. Jonathan B. Orlick, Executive Vice President, General Counsel and Secretary, Gemstar-TV Guide International, Inc. On January 21, 2005, the SEC announced the terms of a settlement with Jonathan B. Orlick, the former Executive Vice President, General Counsel and Secretary of Gemstar-TV Guide International, Inc. 9 Orlick was also a member of the Gemstar board. According to the release, Gemstar is a media and technology company that publishes TV Guide and develops, licenses, and markets an interactive program guide (IPG) for televisions. the Company touted IPG as the value driver of the company s stock. According to the SEC, Gemstar overstated its total revenues by at least $248 million to meet growth projections for IPG licensing revenue. It was also alleged that Orlick repeatedly signed false representation letters to the company s outside auditors regarding the status of negotiations with another company. As part of the settlement, Orlick has been enjoined from violating, or aiding and abetting violations, of securities laws, and Orlick was ordered to pay $305,510.62, representing $150,000 in disgorgement of a prior bonus, $5, interest and a $150,000 civil penalty. In addition, Orlick may not serve as an officer or director of a public company for a period of ten years, and he has been suspended from appearing or practicing before the SEC. Orlick consented to the penalties but neither admitted or denied liability. Corporate Counsel magazine quotes an SEC spokesman as saying, Lawyers for public companies serve a vital role as gatekeepers to our financial markets. The sanctions in this case reflect the seriousness with which we view breaches of the public trust by attorneys. 10 While the facts alleged against Orlick indicate an active participation in Gemstar s material overstatement of revenues, the SEC s continued

9 description of lawyers as gatekeepers underscores a continuing shift of a company lawyer s duties to the marketplace. David C. Drummond, General Counsel, Vice President of Corporate Development and Secretary, Google, Inc. On January 13, 2005, David C. Drummond, consented to a Cease and Desist Order from the SEC. 11 The SEC alleged that Drummond, who was General Counsel, Vice President of Corporate Development and Secretary of Google, Inc., caused Google to violate the securities registration provisions of Section 5 of the Securities Act of 1933 when he advised the Board of Directors that registration of over $80 million in stock option grants did not require financial disclosures to the recipients. From Drummond s titles, it is obvious that he wore multiple hats at Google. One of the SEC s conclusions was that the required disclosures for the stock options would have been strategically disadvantageous, from Google s perspective, a concern recognized by Drummond. One could speculate that Drummond s concern might have been in response to his role as Google s Vice President of Corporate Development, rather than his role as General Counsel. Drummond neither admitted nor denied the allegations, and no monetary penalties were assessed due, at least in part, to Google s and Drummond s cooperation during the Commission staff s investigation. James A. Fitzhenry, Senior Vice-President, General Counsel and Secretary, FLIR Systems, Inc. In a pre-sox enforcement action, the SEC issued a Cease and Desist Order to James A. Fitzhenry, the Senior Vice-President, General Counsel and Secretary of FLIR Systems, Inc. 12 The SEC concluded that Fitzhenry had willfully misled FLIR s outside auditors when he signed two management representation letters confirming that $4.1 million in sales were fixed commitments in which the risk of ownership had passed to the purchaser. In fact, the two transactions were evidenced by non-binding letters of intent, and attempts by Fitzhenry personally to obtain binding commitments had failed. In addition to the Cease and Desist Order, Fitzhenry was also denied the privilege of appearing and practicing before the Commission for a period of five years. Before he can be reinstated he must submit an affidavit to the SEC S General Counsel truthfully stating that he has complied with the SEC order, that he is not subject to suspension or disbarment and that he has not been convicted of a felony or of a misdemeanor involving moral turpitude. In a FLIR Systems filing earlier this year, it reported that Fitzhenry, whose title is now Senior 3 Vice President, Corporate Operations and Law, and Corporate Secretary, received a bonus of $120,000 and options to purchase 40,000 shares of FLIR stock. 13 Stanley P. Silverstein, Vice President, General Counsel and Secretary, The Warnaco Group, Inc. The SEC sanctioned Stanley P. Silverstein, the Vice President, General Counsel and Secretary of the Warnaco Group, Inc., for assisting in the filing of SEC documents that mischaracterized the cause of a restatement of Warnaco s earnings, to correct a $145 million inventory over-evaluation. 14 In a complicated set of facts, Warnaco tried to conceal an inventory write-down as part of the company s adoption of a new accounting standard rather than a failure in its accounting system. In a separate violation, the SEC also found that Silverstein sent a letter to Warnaco s outside auditors confirming that the company had entered into a legally enforceable agreement to use the company s cash to offset debt, when no such agreement had been entered into as of the end of the company s fiscal quarter. Silverstein agreed to a Cease and Desist Order and to not sign any document to be filed with the SEC for a period of two years. As part of its more aggressive attitude about misleading financial information, Silverstein was also required to disgorge a bonus ($165,772 including prejudgment interest) which was received, in part, because Warnaco ignored part of the bonus formula implicated in the mischaracterization of the company s financial write-down. Steven Woghin, Senior Vice President and General Counsel, Computer Associates International, Inc. Steven Woghin, the Senior Vice President and General Counsel of Computer Associates International, Inc., agreed to an SEC sanction of suspension from appearing and practicing before the Commission. 15 The sanction resulted from Woghin s participation in backdating contracts in order to inflate earnings thus leading to filing false and misleading financial statements with the SEC. The SEC also alleged the Woghin counseled other employees to conceal information from attorneys conducting an internal investigation of Computer Associates and from the Commission s staff. This rather lenient sanction may have been due to the fact that on the same day the sanction was entered, Woghin pled guilty to two counts of securities fraud and obstruction of justice. Woghin is now cooperating with the government s continuing investigation and is awaiting sentencing of up to twenty-five years in prison. 16

10 Franklin Brown, Vice Chairman of the Board and General Counsel, Rite Aid Corp. After a trial before a jury, Franklin Brown, the Vice Chairman and General Counsel of Rite Aid Corp., was found guilty of multiple charges related to accounting violations that led the company to overstate earning by $1.6 billion. 17 Even though Brown was 76 at the time, he began serving a ten year prison term on March 1, 2005, something that his counsel described as tantamount to a death sentence. Leonard Goldner, General Counsel, Symbol Technologies, Inc. On October 27, 2004, Leonard Goldner, the former General Counsel of Symbol Technologies, Inc., pled guilty to a scheme in which he and other senior executives at Symbol exploited Symbol s stock option plans to enrich themselves and illegally minimize their tax obligations at the expense of Symbol. 18 In addition to a possible prison term of up to five years and a substantial fine, Goldner has also agreed to forfeit $2 million representing the proceeds of his crime. Goldner was convicted of orchestrating a scheme that allowed himself and other Symbol executives to use a thirty day look back period to determine the date they purportedly exercised stock options in order to realize the least amount of taxable income. In addition to the criminal action, the SEC has also brought civil action against Goldner alleging securities fraud. 19 The SEC s enforcement action was triggered by Goldner s violation of the terms of the company s stock option plan which had been incorporated into an SEC filing by the company. Scott Wiegand, General Counsel, PurchasePro.com, Inc. Scott Wiegand, the former General Counsel of PurchasePro.com, Inc., was indicted along with several other PurchasePro executives and two at America Online. 20 The indictment alleges that Wiegand either caused or had knowledge of specific actions to fraudulently raise revenues. Among other things, Wiegand participated in a conference call with analysts in which the company announced quarterly revenue of $29.8 million, but shortly thereafter the company officially reported revenue of only $16.2 million. Of interest, a parallel SEC civil action against PurchasePro executives does not name Wiegand as a defendant, and his attorney described Wiegand as a whistleblower, not a conspirator. Craig Scott, Chief Financial Officer and General Counsel, FFP Marketing Company, Inc. Craig Scott, the Chief Financial Officer and General Counsel of FFP Marketing Company, Inc., was denied the privilege of appearing and practicing before the Commission as an attorney and as an accountant. 21 Scott s cited offenses related to his role as the company s CFO, but the SEC also imposed sanctions against him as an attorney. Even though the SOX rules say they do not apply to lawyers who are not providing legal services to the client, 22 the Scott case demonstrates that the SEC may still issue sanctions against the attorney for violations that occurred in a situation that was not attorney-client. Scott may apply for reinstatement after a suspension period of three years. III. STATE STANDARDS In 1983 the American Bar Association adopted the Model Rules of Professional Responsibility based on the recommendations of a special commission headed by Robert Kutak. 23 Rule 1.13 is the rule addressing the organization as client and reads as follows: Rule 1.13 Organization as Client (a) A lawyer employed or retained by an organization represents the organization acting through its duly authorized constituents. (b) 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 reasonably necessary in the best interest of the organization. In determining how to proceed, the lawyer shall give due consideration to the seriousness of the violation and its consequences, the scope and nature of the lawyer s representation, the responsibility in the organization and the apparent motivation of the person involved, the policies of the organization concerning such matters and any other relevant considerations. Any measures taken shall be designed to minimize the disruption of the organization and the risk of revealing information relating to the representation to persons outside the organization. Such measures may include among others: 4

11 (1) asking for reconsideration of the matter; (2) advising that a separate legal opinion on the matter be sought for presentation to appropriate authority in the organization; and (3) referring the matter to higher authority in the organization, including, if warranted by the seriousness of the matter, referral to the highest authority that can act on behalf of the organization as determined by applicable law. (c) If, despite the lawyer s efforts in accordance with paragraph (b), the highest authority that can act on behalf of the organization insists upon action, or a refusal to act, that is clearly a violation of law and is likely to result in substantial injury to the organization, the lawyer may resign in accordance with rule (d) In dealing with an organization s directors, officers, employees, members, shareholders or other constituents, a lawyer shall explain the identity of the client when the lawyer knows or reasonably should know that the organization s interest are adverse to those of the constituents with whom the lawyer is dealing. (e) A lawyer representing an organization may also represent any of its directors, officers, employees, members, shareholders or other constituents, subject to the provisions of Rule 1.7. If the organization s consent to the dual representation is required by rule 1.7, the consent shall be given by an appropriate official of the organization other than the individual who is to be represented, or by the shareholders. The revised Texas Rules of Professional Responsibility 24 became effective January 1, Rule 1.12 deals with the same subject and reads as follows: Rule 1.12 Organization as a Client (a) A lawyer employed or retained by an organization represents the entity. While the lawyer in the ordinary course of working relationships may report to, and accept direction from, an entity s duly authorized constituents, in the situations described in paragraph (b) the lawyer shall proceed as reasonably necessary in the best interest of the organization without involving unreasonable risks of disrupting the organization and of revealing information relating to the representation to persons outside the organization. 5 (b) A lawyer representing an organization must take reasonable remedial actions whenever the lawyer learns or knows that: (1) an officer, employee, or other person associated with the organization has committed or intends to commit a violation of a legal obligation to the organization or a violation of law which reasonably might be imputed to the organization; (2) the violation is likely to result in substantial injury to the organization; and (3) the violation is related to a matter within the scope of the lawyer s representation of the organization. (c) Except where prior disclosure to persons outside the organization is required by law or other Rules, a lawyer shall first attempt to resolve a violation by taking measures within the organization. In determining the internal procedures, actions or measures that are reasonably necessary in order to comply with paragraphs (a) and (b), a lawyer shall give due consideration to the seriousness of the violation and its consequences, the scope and nature of the lawyer s representation, the responsibility in the organization and the apparent motivation of the person involved, the policies of the organization concerning such matters, and any other relevant considerations. Such procedures, actions and measures may include, but are not limited to, the following: (1) asking reconsideration of the matter; (2) advising that a separate legal opinion on the matter be sought for presentation to appropriate authority in the organization; and (3) referring the matter to higher authority in the organization, including if warranted by the seriousness of the matter, referral to the highest authority that can act in behalf of the organization as determined by applicable law. (d) Upon a lawyer s resignation or termination of the relationship in compliance with Rule 1.15, a lawyer is excused from further proceeding as required by paragraphs (a), (b) and (c), and any further obligations of the lawyer are determined by Rule (e) In dealing with an organization s directors, officers, employees, members, shareholders or other constituents, a lawyer shall explain the identify of the client when it is apparent that

12 the organization s interests are adverse to those of the constituents with whom the lawyer is dealing or when explanation appears reasonably necessary to avoid misunderstanding on their part. IV. SARBANES-OXLEY RULES The SOX rules address the same areas as the state rules on Organization as Client but with a specific focus on securities law matters. This portion of the paper will go through the SOX rules on a section-by-section basis and attempt to reconcile or contrast them with the similar Texas rules sets forth minimum standards of professional conduct for attorneys appearing and practicing before the Commission in the representation of an issuer. These standards supplement applicable standards of any jurisdiction where an attorney is admitted or practices and are not intended to limit the ability of any jurisdiction to impose additional obligations on an attorney not inconsistent with the application of this part. The significant part of this section is the invocation of supremacy, i.e., Where the standards of a state... jurisdiction where an attorney is admitted or practices conflict with this part, this part shall govern. Early concern focused on the risk that the SOX rules might compel an attorney to take action that would be in direct contradiction of the obligations otherwise applicable to an attorney. As finally adopted, these rules have not proven to be that difficult to reconcile with corresponding state rules Definitions. For purposes of this part, the following definitions apply: (a) Appearing and practicing before the Commission: (1) Means: (i) Transacting any business with the Commission, including communications in any form; (ii) Representing an issuer in a Commission administrative proceeding or in connection with any Commission investigation, inquiry, information request, or subpoena; (iii) Providing advice in respect of the United States securities laws or the Commission's rules or regulations thereunder regarding any document that the attorney has notice will be filed with or submitted to, or incorporated into any document that 6 will be filed with or submitted to, the Commission, including the provision of such advice in the context of preparing, or participating in the preparation of, any such document; or (iv) Advising an issuer as to whether information or a statement, opinion, or other writing is required under the United States securities laws or the Commission's rules or regulations thereunder to be filed with or submitted to, or incorporated into any document that will be filed with or submitted to, the Commission; but (2) Does not include an attorney who: (i) Conducts the activities in paragraphs (a)(1)(i) through (a)(1)(iv) of this section other than in the context of providing legal services to an issuer with whom the attorney has an attorney-client relationship; or (ii) Is a non-appearing foreign attorney. It is the author s opinion that every in-house counsel of an organization whose securities are registered with the SEC should assume that he or she is subject to the SOX rules. Certainly, anyone drafting or signing an SEC filing as an attorney is included in the definition. Subsection (a)(1)(iii) is very expansive in the matters that could draw an in-house attorney into the coverage of the rules. In discussing the definition, the SEC attempts to reassure counsel about the limited breadth of the rule. The SEC specifically said: [A]n attorney must have notice that a document he or she preparing or assisting in preparing will be submitted to the Commission to be deemed to be appearing and practicing under the revised definition. The definition... clarifies that an attorney s preparation of a document (such as a contract) which he or she never intended to or had notice would be submitted to the Commission or incorporated into a document submitted to the Commission, but which subsequently is submitted to the Commission as an exhibit to or in connection with a filing, does not constitute appearing and practicing before the Commission. 25 In-house counsel should be aware, however, that the expanded Form 8-K rules require many more filings with the SEC, and an easy way to satisfy the disclosure requirements for a material contract is to attach a copy of the contract to the 8-K filing. 26 Thus, a labor attorney who prepares a simple termination agreement for a corporate officer should generally assume that the contract will become part of the company s next 8-K.

13 The ABA comments expressed concern that the rule, as adopted, could inappropriately encompass nonsecurities specialists who do no more than prepare or review limited portions of a filing, lawyers who respond to auditors letters or prepare work product in the ordinary course unrelated to securities matters Notwithstanding the stated concern, the SEC rejected the ABA s proffered alternative definition that would have had the rule apply only to those lawyers with significant responsibility for the company s compliance with United States securities laws Clearly, if an in-house lawyer participates in the preparation of any portion of an SEC filing such as reviewing the accuracy of a transaction described in a Form 10-K, that lawyer is covered, but the lawyer may also be covered if he or she reviews pending litigation with the company s outside auditors, since the evaluation of litigation risk will be incorporated into the company s audited financials. (b) Appropriate response means a response to an attorney regarding reported evidence of a material violation as a result of which the attorney reasonably believes: (1) That no material violation, as defined in paragraph (i) of this section, has occurred, is ongoing, or is about to occur; (2) That the issuer has, as necessary, adopted appropriate remedial measures, including appropriate steps or sanctions to stop any material violations that are ongoing, to prevent any material violation that has yet to occur, and to remedy or otherwise appropriately address any material violation that has already occurred and to minimize the likelihood of its recurrence; or (3) That the issuer, with the consent of the issuer's board of directors, a committee thereof to whom a report could be made pursuant to 205.3(b)(3), or a qualified legal compliance committee, has retained or directed an attorney to review the reported evidence of a material violation and either: (i) Has substantially implemented any remedial recommendations made by such attorney after a reasonable investigation and evaluation of the reported evidence; or (ii) Has been advised that such attorney may, consistent with his or her professional obligations, assert a colorable defense on behalf of the issuer (or the issuer's officer, 7 director, employee, or agent, as the case may be) in any investigation or judicial or administrative proceeding relating to the reported evidence of a material violation. This definition is relevant to an attorney s duty under the SOX rules and will be discussed, infra. (c) Attorney means 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. This definition is straight forward, but other SOX rules make clear that the Standards of Professional Conduct only apply to attorneys who are functioning in that capacity, not others who are licensed attorneys, but who are filling other roles. (d) Breach of fiduciary duty refers to any breach of fiduciary or similar duty to the issuer recognized under an applicable federal or state statute or at common law, including but not limited to misfeasance, nonfeasance, abdication of duty, abuse of trust, and approval of unlawful transactions. (e) Evidence of a material violation means credible evidence, based upon which it would be unreasonable, under the circumstances, for a prudent and competent attorney not to conclude that it is reasonably likely that a material violation has occurred, is ongoing, or is about to occur. This definition is substantially revised from the proposed rule in order to establish an objective standard. The proposed rule would have defined evidence of a material violation as information that would lead an attorney reasonably to believe that a material violation has occurred, is occurring, or is about to occur. 29 The SEC rejected a proposal that this definition incorporate the need for an actual belief in favor of credible evidence that would make it unreasonable not to conclude that a material violation had occurred. 30 The SEC notes that while the definition is intended to articulate an objective standard, there is a range of conduct in which an attorney may engage without being unreasonable, and an attorney is not required (or expected) to report gossip, hearsay, [or] innuendo. 31 The SEC s discussion states that the definition incorporates reasonably likely that a material violation has occurred. This is standard higher than a mere possibility but not more likely than not. 32

14 (f) Foreign government issuer.. (g) In the representation of an issuer means providing legal services as an attorney for an issuer, regardless of whether the attorney is employed or retained by the issuer. This is a curious definition in that it seems to negate the need to have established an attorney/client relationship. The definition is intended to cover an attorney employed by an investment advisor who prepares, or assists in preparing materials, on behalf of a client. 33 (h) 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, but does not include a foreign government issuer. For purposes of paragraphs (a) and (g) of this section, the term "issuer" includes any person controlled by an issuer, where an attorney provides legal services to such person on behalf of, or at the behest, or for the benefit of the issuer, regardless of whether the attorney is employed or retained by the issuer. (i) Material violation means a material violation of an applicable United States federal or state securities law, a material breach of fiduciary duty arising under United States federal or state law, or a similar material violation of any United States federal or state law. Materiality is a subjective standard and will vary from company to company. Generally speaking, something is material if there is a substantial likelihood that a reasonable investor would consider it important in deciding where to buy, hold, or sell as security. 34 Thus, a material violation would be one, the result of which could affect the market s evaluation of a security. (j) Non-appearing foreign attorney.... (k) Qualified legal compliance committee means a committee of an issuer (which also may be an audit or other committee of the issuer) that: (1) Consists of at least one member of the issuer's audit committee (or, if the issuer has no audit committee, one member from an equivalent committee of independent directors) and two or more members of 8 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)); (2) Has adopted written procedures for the confidential receipt, retention, and consideration of any report of evidence of a material violation under 205.3; (3) Has been duly established by the issuer's board of directors, with 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 205.3(b)(4)); (ii) To determine whether an investigation is necessary regarding any report of evidence of a material violation by the issuer, its officers, directors, employees or agents and, if it determines an investigation is necessary or appropriate, 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, to: (A) Recommend, by majority vote, that the issuer implement an appropriate response to evidence of a material violation; 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 this section and the appropriate remedial measures to be adopted; and

15 (4) Has the authority and responsibility, acting by majority vote, to take all other appropriate action, including the authority to notify the Commission in the event that the issuer fails in any material respect to implement an appropriate response that the qualified legal compliance committee has recommended the issuer to take. The concept of a qualified legal compliance committee ( QLCC ) does not appear anywhere in state rules related to representing the organization as client. Nonetheless, a QLCC could constitute a higher authority in the organization as provided in Texas Rule 1.12(c)(3). The provision for a QLCC is a creature of the SEC s rulemaking process. Section 307 of the Sarbanes- Oxley Act does not mention QLCC s, although it does make reference to another committee of the board comprised solely of directors not employed directly or indirectly by the issuer. An Issuer s Audit Committee meets the requirements of a QLCC, and the Audit Committee could be separately designated as the Issuer s QLCC. A QLCC, whether the Audit Committee or otherwise, must be so designated before a legal issue arises that the Issuer wants to refer to its QLCC. (l) Reasonable or reasonably denotes, with respect to the actions of an attorney, conduct that would not be unreasonable for a prudent and competent attorney. (m) Reasonably believes means that an attorney believes the matter in question and that the circumstances are such that the belief is not unreasonable. In the section on Terminology in the Preamble to the Texas Rules, Reasonable or Reasonably is defined as denoting conduct of a reasonably prudent and competent lawyer, and reasonably believes is defined to denote that the lawyer believes the matter in question and that the circumstances are such that the belief is reasonable. (n) Report means to make known to directly, either in person, by telephone, by , electronically, or in writing. Section Issuer as client. (a) Representing an Issuer. An attorney appearing and practicing before the Commission in the representation of an issuer owes his or her professional and ethical duties to the issuer as an organization. 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. The SEC s proposed rule was significantly different from the final rule. It provided that an attorney was to act in the best interest of the issuer and its shareholders. 35 The SEC abandoned the reference to shareholders as being inconsistent with traditional understandings of representing the organization as client and as implying a potential right of action were an attorney to be alleged to have violated a duty to a shareholder. Even though the SEC backed away from including shareholders as clients, subsequent SEC actions, as discussed in Section II above, appear to have added the marketplace as an entity to which an issuer s attorney owes a duty. The ABA s Model Rule 1.13(b) provides that an attorney must proceed as reasonably necessary in the best interest of the organization if an officer or employee is engaged in an action, intends to act or not act in violation of a legal obligation or violates a law that is likely to result in injury to the organization. The Texas rule does not contain similar language, but Comment 6 to the Texas rule clarifies that [d]ecisions concerning policy and operations, including ones entailing serious risk, are not, as such, in the lawyer s province. The SEC adopted the same position with respect to corporate decisions traditionally reserved to management. (b) Duty to report evidence of a material violation. (1) If an attorney, appearing and practicing before the Commission in the representation of an issuer, becomes aware of evidence of a material violation by the issuer or by any officer, director, employee, or agent of the issuer, the attorney shall report such evidence to the issuer's chief legal officer (or the equivalent thereof) or to both the issuer's chief legal officer and its chief executive officer (or the equivalents thereof) forthwith. By communicating such information to the issuer's officers or directors, an attorney does not reveal client confidences or secrets or privileged or otherwise protected information related to the attorney's representation of an issuer. This provision is the obvious core of the SOX rules. Anytime an attorney believes there is evidence of a material violation by the regulated entity or one of its officers, employees or agents, then the attorney must report such evidence to the chief legal officer or to both the chief legal officer and chief executive officer. By 9

16 statutory stipulation, this is not a disclosure of privileged or protected information. The requirement of this SOX rule substantially short circuits the Texas rule that imposes measured steps on the organization s attorney, as follows. 1. Texas rule creates a duty if there is a likelihood of substantial injury to the organization vs. SOX evidence of a material violation. 2. Texas rule limits action to those matters within the scope of the lawyer s representative vs. SOX requirement to act on evidence of a material violation regardless of the basis for knowledge thereof or the lawyer s expertise in the area of the possible material violation. 3. Texas rule instructs an attorney to seek resolution within the organization with due consideration to (i) the seriousness of the violation and its consequences; (ii) the scope and nature of the attorney s representation; (iii) the responsibility within the organization and motivation of the person involved; (iv) the organization s policies; and (v) other relevant matters. The attorney may then: a. Ask for reconsideration; b. Advise the need for separate legal opinion; or c. Refer the matter to higher authority, which is the first step under the SOX rule. Evidence of a material violation is not gossip, hearsay, or innuendo, but if a lawyer is suspicious that a material violation is reasonably likely to have occurred, evidence thereof need not be more likely than not to be true. This SEC standard elevates an in-house lawyer s responsibility well above the Texas standard because it imposes a duty to act on information even if it is outside the lawyer s area of expertise. Texas Rule 1.12(b)(3) only requires that a lawyer take remedial action if the violation is related to a matter within the scope of the lawyer s representation of the organization. A lawyer in the tax section of a company is under no professional duty, under the Texas rule, to address an organization s possible violation of an OSHA statute, an area about which the tax lawyer may not be sufficiently well informed to make a sound evaluation. The proposed SOX rules would have required an attorney reporting evidence of a material violation to document the report and any response thereto and to retain such documentation for a reasonable time. The SEC apparently thought such a record would rebut any suspicion of that attorney s participation in a fraud. However, a number of commenters objected because of the distrust it might engender between an attorney and the client, and if discovered, it would be a treasure trove 10 of selectively damning evidence. 36 Ultimately, the SEC chose not to include this requirement in the SOX rules. (2) The chief legal officer (or the equivalent thereof) shall cause such inquiry into the evidence of a material violation as he or she reasonably believes is appropriate to determine whether the material violation described in the report has occurred, is ongoing, or is about to occur. If the chief legal officer (or the equivalent thereof) determines no material violation has occurred, is ongoing, or is about to occur, he or she shall notify the reporting attorney and advise the reporting attorney of the basis for such determination. Unless the chief legal officer (or the equivalent thereof) reasonably believes that no material violation has occurred, is ongoing, or is about to occur, he or she shall take all reasonable steps to cause the issuer to adopt an appropriate response, and shall advise the reporting attorney thereof. In lieu of causing an inquiry under this paragraph (b), a chief legal officer (or the equivalent thereof) may refer a report of evidence of a material violation to a qualified legal compliance committee under paragraph (c)(2) of this section if the issuer has duly established a qualified legal compliance committee prior to the report of evidence of a material violation. This SOX rule has no equivalent counterpart in the Texas rules although it is reasonable to assume that a chief legal officer ( CLO ) of an organization has the same responsibilities as any other attorney of an organization to comply with Rule 1.12 once the CLO learns of the risk of a violation of a legal obligation. Nothing in the Texas rule speaks to a CLO s duty to cause an inquiry to be made or to report back to the attorney who provided the initial evidentiary basis for a concern. Unless the CLO reasonably believes there is no material violation, the CLO shall take all reasonable steps to cause the issuer to adopt an appropriate response, and shall advise the reporting attorney thereof. This assumes a level of authority on the part of the CLO which may not always be warranted. (3) Unless an attorney who has made a report under paragraph (b)(1) of this section reasonably believes that the chief legal officer or the chief executive officer of the issuer (or the equivalent thereof) has provided an appropriate response within a

17 reasonable time, the attorney shall report the evidence of a material violation to: (i) The audit committee of the issuer's board of directors; (ii) Another committee of the issuer's board of directors consisting solely of directors who are not employed, directly or indirectly, by the issuer and 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)) (if the issuer's board of directors has no audit committee); or (iii) The issuer's board of directors (if the issuer's board of directors has no committee consisting solely of directors who are not employed, directly or indirectly, by the issuer and 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)). (4) If an attorney reasonably believes that it would be futile to report evidence of a material violation to the issuer's chief legal officer and chief executive officer (or the equivalents thereof) under paragraph (b)(1) of this section, the attorney may report such evidence as provided under paragraph (b)(3) of this section. These two sections of the SOX rules maintain a continuing duty on the attorney who first reports evidence of a material violation. Rule 205.3(b)(3) has a twofold test for the attorney: (1) that he or she has been provided with an appropriate response; and (2) within a reasonable time. If either test is not met, the reporting attorney must continue to move up the ladder. Arguably, this is consistent with Texas Rule 1.12(c) which requires an attorney to move up the ladder to the highest authority that can act on behalf of the organization. That is usually going to be the board of directors which is one of the options in the SOX rule. The SOX rule, however, may place an unreasonable burden on the reporting attorney to evaluate whether he or she has received an appropriate response under Rule 205.3(b)(3) or that it would be futile to report to the CLO under Rule 205.3(b)(4). Notwithstanding the SEC s conclusion that neither rule is controversial, 37 an error in judgment about either of those matters could 11 become a career limiting event, while excessive deference to the CLO could also be the basis for an SEC enforcement action against the reporting attorney. Rules 205.3(b)(8) and (b)(9) below attempt to resolve those concerns, but they may not be dispositive in a debate about whether an attorney s conclusions were reasonable. (5) An attorney retained or directed by an issuer to investigate evidence of a material violation reported under paragraph (b)(1), (b)(3), or (b)(4) of this section shall be deemed to be appearing and practicing before the Commission. Directing or retaining an attorney to investigate reported evidence of a material violation does not relieve an officer or director of the issuer to whom such evidence has been reported under paragraph (b)(1), (b)(3), or (b)(4) of this section from a duty to respond to the reporting attorney. (6) An attorney shall not have any obligation to report evidence of a material violation under this paragraph (b) if: (i) The attorney was retained or directed by the issuer's chief legal officer (or the equivalent thereof) to investigate such evidence of a material violation and: (A) The attorney reports the results of such investigation to the chief legal officer (or the equivalent thereof); and (B) Except where the attorney and the chief legal officer (or the equivalent thereof) each reasonably believes that no material violation has occurred, is ongoing, or is about to occur, the chief legal officer (or the equivalent thereof) reports the results of the investigation to the issuer's board of directors, a committee thereof to whom a report could be made pursuant to paragraph (b)(3) of this section, or a qualified legal compliance committee; or (ii) The attorney was retained or directed by the chief legal officer (or the equivalent thereof) to assert, consistent with his or her professional obligations, a colorable