Vol. 76, No. 3, March 2003

Sarbanes-Oxley Requirements

Determining Disclosure Under SEC Reporting Requirements

by Dean R. Dietrich

Question

I heard about new federal legislation that requires a lawyer to disclose confidential information about a corporate client. What does this new legislation require and what obligations do I have to give out client information?

Answer

In July, Congress passed the Sarbanes-Oxley Act, legislation that addresses several issues regarding financial accounting standards and financial reporting requirements for publicly traded companies. As a part of this legislation, Congress required the Securities and Exchange Commission (SEC) to develop rules that address the conduct of lawyers who are representing publicly traded companies before the SEC.

Under the mandate of the federal legislation, the SEC initially developed rules that addressed the requirement that a lawyer report any inappropriate conduct of a publicly traded company or officers or directors of that company to appropriate individuals within the company, known as reporting "up the ladder," and required lawyers to withdraw from representation and advise the SEC of the withdrawal (known as "noisy withdrawal") if no corrective action was taken. Under the final rule recently issued by the SEC, a lawyer is required to report material violations of securities laws or accounting practices "up the ladder" to corporate officials or boards. The SEC postponed issuance of the proposed rule that required a lawyer who is aware of a material violation of the law or fraudulent acts of a corporate officer to withdraw from representation of the company and disavow any legal opinions or statements that the lawyer participated in as part of the representation of the publicly traded company. The proposed rule is subject to a further comment period.

Guiding Principles. While the SEC rules are very complex, there are several principles that apply when considering a lawyer's obligation to report information if the lawyer reasonably concludes that the company/client is acting in violation of the SEC rules. First, under section 205.3 (a) of the rules, any attorney who is appearing or practicing before the SEC in the representation of an issuer is deemed to be representing the organization and is obligated to act in the best interest of the issuer and its shareholders. This concept is consistent with the language of SCR 20:1.13, which clarifies that a lawyer representing an organization is actually representing the entity itself and must act in the best interests of the entity, not individual officers or directors of the entity.

Second, an attorney who becomes aware of "evidence of a material violation by the issuer or by any officer, director, employee, or agent of the issuer" must report any evidence of a material violation to the entity's chief legal officer or both the entity's chief legal officer and its chief executive officer. This requirement also is consistent with a Wisconsin lawyer's obligation under SCR 20:1.13 if the lawyer becomes aware of conduct by an individual that is harmful to the organization that is the lawyer's client. A material violation is defined to mean a material violation of the securities laws, a material breach of fiduciary duty, or a similar material violation. A breach of fiduciary duty would cover such types of conduct as misfeasance, nonfeasance, abdication of duty, abuse of trust, and the approval of unlawful transactions. The final draft of the rule contains a new provision that defines the type of evidence that must be found for a report of wrongdoing to be required as "credible evidence, based upon which it would be unreasonable, under the circumstances, for a prudent and competent attorney not to conclude that it is reasonably likely that a material violation has occurred, is ongoing, or is about to occur."

Third, the attorney who becomes aware of evidence of a material violation must report the evidence either to the audit committee of the entity's board of directors or to the board of directors of the entity, if the attorney does not receive an appropriate response or a response within a reasonable time from the chief legal officer and/or the chief executive officer. This duty to report "up the ladder" to the board of directors or appropriate committee is again consistent with SCR 20:1.13, which requires a lawyer to report the evidence of the inappropriate conduct to the highest appropriate authority.

If the lawyer receives a timely and appropriate response to the report of evidence of a material violation, the lawyer does not need to take any further action. If, however, the lawyer does not receive an appropriate response or does not receive a response in a reasonable time, the attorney must explain the reasons why he or she believes that the response is not appropriate or is untimely to the chief legal officer, chief executive officer, or board of directors to whom the lawyer has previously reported the evidence of a material violation. In effect, the lawyer is obligated to report a second time regarding the evidence of a material violation if no response or an inappropriate response is received after the first report is made.

Proposed Rule - Additional Reporting. The proposed SEC rule that is under study for another 60-day comment period requires the lawyer to go further in reporting evidence of a material violation. If no appropriate action is taken after reporting "up the ladder," the lawyer is then placed under a new obligation. If the lawyer believes that a material violation is "ongoing or is about to occur and is likely to result in substantial injury to the financial interest or property of the issuer or of investors," the lawyer must:

1) withdraw from representation of the issuer entity and indicate to the entity that the lawyer is withdrawing based upon "professional considerations;"

2) give written notice to the SEC, within one business day of withdrawing, that the attorney is withdrawing from representation based "on professional considerations;" and

3) promptly disaffirm to the SEC "any opinion, document, affirmation, representation, characterization, or the like in a document filed with or submitted to the Commission ... that the attorney has prepared or assisted in preparing and that the attorney reasonably believes is or may be materially false or misleading."

This is known as a "noisy withdrawal." The attorney is not required to disclose facts or evidence of the material violation to the SEC but rather is only obligated to notify the SEC that the attorney is withdrawing from representation for professional considerations and to disaffirm any documents that the attorney was involved in preparing on behalf of the entity to the extent the attorney may know that the document is or may be materially false or misleading.

This obligation to engage in a "noisy withdrawal" is similar to the obligation of SCR 20:1.6 (b), which requires Wisconsin lawyers to disclose confidential attorney/client information if the lawyer "reasonably believes (it) necessary to prevent a client from committing a criminal or fraudulent act that the lawyer reasonably believes is likely to result in death or substantial bodily harm or in substantial injury to the financial interest or property of another." As can be seen, the language of SCR 20:1.6, while relating to an obligation to disclose information necessary to prevent an act from occurring, does apply to information that could result in substantial injury to the financial interest or property of another _which is the same language incorporated in Rule 205.3.

Under the proposed rule, if a lawyer has reported evidence of a material violation and does not receive an appropriate or timely response and the lawyer believes that a material violation has already occurred and is likely to have resulted in substantial injury to the financial interest or property of the issuer or investors but is not an ongoing violation, the lawyer may 1) withdraw from representing the entity and indicate that the withdrawal is based on professional considerations, 2) give written notice to the SEC of the withdrawal based on professional considerations, and 3) disaffirm in writing any opinion, document, affirmation, representation, characterization, or the like in a document that the attorney prepared or assisted in preparing if the attorney believes that the information may be materially false or misleading. This requirement is similar to the language in SCR 20:1.6 (c), which provides that a lawyer may disclose information learned during the course of representing a client in order to address the consequences of a fraudulent or criminal act committed by the client through the use of the lawyer's services. This language is permissive instead of mandatory, which allows the attorney to determine whether or not he or she wishes to disclose evidence of a material violation to the SEC when the violation is not believed to be ongoing.

The proposed SEC rule still under study contains a somewhat different procedure for persons employed by the issuer. In similar instances when an attorney employed by the issuer becomes aware of a material violation, the attorney must report the information to the appropriate officer and "up the ladder" if necessary. If such report does not resolve the matter, the attorney is obligated to: 1) notify the entity in writing that the attorney intends to disaffirm some opinion, document, affirmation, representation, characterization, or similar statement in a document filed or submitted to the SEC that the attorney has prepared or assisted in preparing if the attorney reasonably believes that the document may be materially false or misleading; and 2) promptly disaffirm any such document by notice to the SEC in writing.

The final rule also provides that a lawyer practicing before the SEC in the representation of an issuer may reveal confidential information related to the representation if the lawyer reasonably believes it necessary to prevent the issuer from committing an illegal act that the lawyer reasonably believes is likely to result in substantial injury to the financial interest or property of the issuer or investors; to prevent the issuer from committing an illegal act that is likely to perpetuate a fraud upon the SEC; or to rectify the consequences of an issuer's illegal act in the furtherance of which the attorney's services were used. These discretionary reporting requirements coincide with the requirements of SCR 20:1.6 (c), which provides that the lawyer may disclose information related to a client representation based upon similar circumstances.

Conclusion

The practical effect of all these provisions is to place a limited additional burden on Wisconsin lawyers to report information to the client and perhaps to the SEC if the criteria of the rules are met. In each instance, the lawyer must believe that a material violation of the SEC rules is either occurring or has occurred. Similar obligations already exist under Supreme Court Rule 20:1.6, although lawyers practicing before the SEC may be required to give a "noisy withdrawal" notice to their client and to the SEC if the circumstances of a material violation are not properly addressed by the entity.

Lawyers practicing before the SEC or representing publicly traded companies should be aware of their obligations under these rules as well as under the Wisconsin Supreme Court Rules of Professional Conduct for Attorneys.

Wisconsin Lawyer