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Derivatives, Issuers & Counsel: Reporting of Material Violations

Recent corporate scandals, including the fall of Enron, have focused attention on the role of attorneys who represent public companies. The American Bar Association Model Rules of Professional Responsibility were amended in August to permit lawyers to reveal confidential client information to prevent the client from committing a financial crime or fraud and to require a lawyer to refer violations of law by employees of the client to higher authorities within the organization.

In January, the Securities and Exchange Commission adopted a mandatory up-the-ladder reporting rule for issuer's counsel. Many entities involved in derivatives transactions, including public commodity pools and special purpose investment vehicles, may be classified as issuers under this rule.

Reporting Up Rule

The Commission adopted rule 205, implementing standards of professional conduct for attorneys for issuers. The rule requires attorneys appearing and practicing before the Commission in the representation of an issuer to report credible evidence of a material violation up-the-ladder within the issuer's organization (the Reporting Up Rule). The Reporting Up Rule is similar to the new ABA organization rule. The attorney is required to comply with the Reporting Up Rule if he or she becomes aware of credible evidence, based upon which it would be unreasonable, under the circumstances, for a prudent and competent attorney not to conclude that it is reasonably likely that a material violation has occurred, is occurring or is about to occur.

The rule requires an attorney to report such evidence to the issuer's chief legal officer or to both its CLO and CEO. The issuer's CLO is required to inquire into the evidence of the material violation and, unless he or she reasonably believes that no material violation has occurred, is ongoing, or is about to occur, must take reasonable steps to cause the issuer to adopt an appropriate response to the attorney's report.

Appropriate responses include: (i) appropriate remedial measures 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; (ii) a response that leads the reporting attorney to reasonably believe that no material violation has occurred, is occurring or is about to occur and (iii) the retention by the issuer of an attorney to review the report and that the issuer has either implemented such attorney's remedial recommendation or has been advised that the attorney will assert a colorable defense relating to the reported evidence of the material violation.

Unless an attorney who has made a report of a material violation reasonably believes that there has been an appropriate response within a reasonable period to his or her report, the attorney must report the evidence to an appropriate committee of the issuer's board of directors. An attorney retained or employed by an issuer that has established a director-level qualified legal compliance committee to consider and investigate attorney reports under the Reporting Up Rule and to recommend appropriate responses to such reports may, as an alternative to the reporting requirements described above, report evidence of a material violation to the QLCC. The Reporting Up Rule does not require either an attorney or an issuer to report evidence of a material violation, or an issuer's response to such evidence, to the Commission, although the attorney may report such evidence to the Commission under certain circumstances without the consent of the issuer.

Reporting Out Proposals

In November 2002, when the Commission first proposed the Reporting Up Rule, it also proposed other provisions that the Commission considered minimum standards for attorneys who appear and practice before the Commission in the representation of issuers. These provisions would have required attorneys who report a material violation up-the-ladder within the issuer but who do not receive a timely appropriate response to noisily withdraw from further representation of the issuer, i.e., to report outside of the issuer and notify the Commission that they have reported up-the-ladder within the issuer and disaffirm documents filed or submitted to the Commission on behalf of the issuer.

Based on negative comments, the Commission proposed an alternative rule that requires the issuer--not the issuer's attorney--to notify the Commission that, after failing to receive an appropriate response to a report to the issuer of a material violation, its attorney withdrew from further representation of the issuer because of professional considerations and the circumstances surrounding the withdrawal. This procedure notifies the Commission of the attorney's withdrawal, or, in the case of an in-house attorney, of his or her cessation of work on the matter, and that it arose from the issuer's failure to appropriately respond to the attorney's report of a material violation.

The Issuer Reporting Out Proposal does not contain a mandatory noisy withdrawal requirement imposed on an issuer's counsel. It requires attorney action when the attorney reasonably concludes that there is substantial evidence that a material violation is ongoing or about to occur and is likely to cause substantial injury to the issuer or investors. The Issuer Reporting Out Proposal requires the issuer (rather than its attorney) to report out to the Commission an attorney's written notice of withdrawal based on the attorney not receiving an appropriate response from the issuer. The issuer's attorney is permitted, but not required, to inform the Commission of his or her withdrawal if the issuer does not comply with the notification requirement.

Comment Letters

In a joint comment letter to the Commission, 79 law firms opined that the Issuer Reporting Out Proposal does not address the problem of the impact of a required notice to the Commission on the free exchange of information between attorneys and clients. The 79 law firms concluded that "in the vast majority of cases, counsel enjoy the confidence of their clients and, given access to the facts by their clients, succeed in persuading their clients to refrain from actions that harm the investing public." They warned that "clients will understand the potential adverse consequences of consulting counsel," with the result that "some issuers may begin to err on the side of less rather than more consultation with their attorneys about potentially difficult situations." The 79 law firms recommended that the Commission's objective was already achieved by the Reporting Up Rule, as discussed earlier. The ABA also recommended that the Commission either defer or not adopt the Issuer Reporting Out Proposal. When DW went to press the Commission had not yet adopted or withdrawn either the Attorney Reporting Out Proposal or the Issuer Reporting Out Proposal.

Attorneys for Service Providers

An attorney must be both providing legal services to an issuer within the context of the attorney-client relationship and appearing and practicing before the Commission to be covered by the Commission's Reporting Up Rule. "Appearing and practicing" before the Commission means (i) transacting any business with the Commission on behalf of the issuer, including communications in any form, (ii) representing the issuer in connection with a Commission investigation or proceeding, (iii) providing the issuer with advice on U.S. securities laws or Commission regulations regarding any document that the attorney has notice will be filed with, submitted to, or incorporated into, any Commission filing or submission, including providing advice in the context of preparing or participating in the preparation of such document, or (iv) advising an issuer as to whether information or a statement is required to be filed with, submitted to, or incorporated into, a Commission filing or submission. Subordinate attorneys may comply with the new rules by reporting evidence of a material violation to a supervising attorney, such as the in-house CLO, who in turn must comply.

Who It Covers

The Reporting Up Rule applies not only to attorneys retained or employed directly by the issuer itself, but also to any person controlled by the issuer when the attorney provides legal services to the issuer or such person on behalf of, at the behest of, or for the benefit of the issuer, regardless of whether the attorney is employed or retained by the issuer. The Commission's staff has construed the Reporting Up Rule as being applicable to lawyers representing entities providing services to an issuer, such as an investment adviser to an issuer that is a registered investment company. According to the Commission's staff, an attorney employed by an 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 the investment adviser, is representing the investment company before the Commission. The staff of the Commission is of the view that the investment adviser is an agent of the investment company and owes the investment company fiduciary duties under both common law and the Investment Company Act of 1940 and that the attorney employed by the investment adviser has joint clients for the purpose of the Reporting Up Rule. In this author's view, lawyers for commodity trading advisors to public commodity pools and for swap providers to special purpose investment vehicles should consider the potential implications of the Reporting Up Rule.

This week's Learning Curve was written by Michael Sackheim, attorney at Sidley Austin Brown & Wood LLPin New York.

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