Reporting Up and Out The Sarbanes-Oxley Act of 2002 Public Company Accounting Reform and Corporate Responsibility

1Reporting Up and Out The Sarbanes-Oxley Actof 2002 Public Company Accounting Reform and Corporate Responsibility

15 U.S.C. 724517 CFR 205.1 Ch. 6 - Confidentiality - SOX - reporting up and out1Statutory mandateSpecial problems of confidentiality: Criminal or Fraudulent ConductReporting Up and Reporting Out

Reporting Up: reporting a crime or fraud within the organizationReporting Out: disclosure to anyone outside the organization

Under The Model Rules of Professional Conduct and the Sarbanes Oxley Act

Sarbanes Oxley and Representing Publicly Traded Corporations

Kinds of reportable corporate wrongdoing

Expenses incorrectly booked as capital investments (Worldcom)Waste of assets ($2 million Roman toga party for CEO s wifes birthday) (Tyco)Loans to officers unjustified by corporate purpose (Adelphia)Round-trip phony trades to puff up revenues (Enron)

Q. 6-25 p. 616 Sarbanes Oxley DutiesL&C potentially faces: (A) sanctions under the Sarbanes-Oxley regulations. (B)sanctions under Sarbanes Oxley regulations and discipline under the Rules. (C)discipline under the RPCs but not SOX. (D)none of the above.

Ch. 6 - Confidentiality - SOX - reporting up and out2Correct Answer: (C) This question is based generally on the facts of the Enron case and examines whether the Sarbanes-Oxley regulations promulgated in response to Enron would have prevented the Enron problem. The Sarbanes-Oxley Regulations, 17 C.F.R. 205.3, Casebook p. 617, require lawyers appearing and practicing before the Commission to report evidence of a material violation . . . to the issuers chief legal officer . . . or to both the issuers chief legal officer and its chief executive officer. Unless the attorney who has made the report . . . reasonably believes that the chief legal officer or the chief executive officer . . . has provided an appropriate response within a reasonable time, the attorney shall report the evidence of a material violation to: (i) [t]he audit committee of the issuers board of directors, (ii) [a]nother committee of independent directors if the issuers board of directors has no audit committee[;] or [t]he issuers board of directors . . . if the board of directors has no committee of independent directors. 17 CFR 205.3 (b). (Note that the attorney has no obligation to report [i]f the attorney was retained or directed . . . to investigate such evidence of a material violation. . . [or] to assert . . . a colorable defense on behalf of the issuer[.]) If the client has established a qualified legal compliance committee[,] the lawyer may report evidence of a material violation directly to that committee and need not follow-up as required if the lawyer reports to the chief legal officer and/or chief executive officer. 17 CFR 205.3 (c). Here, because it did not investigate, L&C had no evidence of a material violation and no obligation to report. With regard to the Rules, L&C had no obligation to disclose under Rule 1.6 because disclosure under that Rule is discretionary and no obligation to report up or disclose under Rule 1.13, or to refrain from offering assistance under Rule 1.2(d), because L&C did not have knowledge of the violation. However, L&C did violate Rule 1.1 by failing to investigate the transaction adequately. The Comment to Rule 1.1 explains that [c]ompetent handling of a particular matter includes inquiry into and analysis of the factual and legal 1 76 elements of the problem and that [t]he required attention and preparation are determined in part by what is at stake; major litigation and complex transactions ordinarily require more extensive treatment[.] 2Contra-indicationsDan is in-house assistant general counsel at GSKAmulex a GSK product is alleged in a JAMA article to cause an increase in heart attacksAn internal memo by GSK researchers says the safety profile of Amulex has been strongly questioned. We lack the data needed to rebut the critics assertions.

3Ch. 6 - Confidentiality - SOX - reporting up and out34Contra-indicationsMarketing circulates a memo to house counsel in advance of the regular monthly conference call with investment analysts, saying "If anyone should ask regarding the recently filed Amulex product liability cases, our response will be: Counsel has looked at this case and determined it is without merit. Ch. 6 - Confidentiality - SOX - reporting up and out45Contra-indications We stand by the safety of Amulex and look forward to continued growth in this vital market. Responsible use of medicines is the duty of every patient and prescribing physician."

How should Dan respond to the analyst?Under what circumstance would he be required to report upCh. 6 - Confidentiality - SOX - reporting up and out5a paradigm shiftLawyers as gatekeepersCh. 6 - Confidentiality - SOX - reporting up and out66Who is the client?OfficersBoard of DirectorsEmployeesShareholdersThe organization itselfWhat is the duty owed if something occurs or is about to occur that breaks the law?Ch. 6 - Confidentiality - SOX - reporting up and out78Reporting Up in the Publicly Traded CorporationShareholders[QLCC - Qualified Legal Compliance Committee - 17 CFR 205.2 (k)]Board of Directors (audit committee-compensation committee-finance committee)CEOCFOOther officerslower level employees

Ch. 6 - Confidentiality - SOX - reporting up and out88Structure of the Publicly Traded CorporationshareholdersQLCC - Qualified Legal Compliance Committee 17 CFR 205.2 (k)board of directors(audit committee-compensation committee-finance committee)CEOCFOOther officerslower level employees915 U.S.C. 7245 Rules of professional responsibility for attorneys(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 companyCh. 6 - Confidentiality - SOX - reporting up and out9Mandatory reporting upEVIDENCE not knowledge of a crime or fraudTo CLO, CEO (or the equivalent thereof); andCompare MR 1.13 (b) if a lawyer knows that a constituent intends to actand the violation is likely to result in substantial injury to the organizationSOX doesnt care about the organization it care about the integrity of the market!R. 1.13 (b) compels reporting UP but (c) permits reporting out it the highest authority has failed to act appropriately, then IF the violation is reasonably certain to cause substantial injury to the organization It is not focused on the public interest or that of others but on the attorney-client relationship

1015 U.S.C. 7245 Rules of professional responsibility for attorneys(2) if the counsel or officer does not appropriately respond to the evidence (adopting, as necessary, appropriate remedial measures or sanctions), requiring the attorney to report the evidence toCh. 6 - Confidentiality - SOX - reporting up and out10Not later than 180 days after July 30, 2002

1115 U.S.C. 7245 Rules of professional responsibility for attorneys 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.

Ch. 6 - Confidentiality - SOX - reporting up and out111215 U.S.C. 7245 Rules of professional responsibility for attorneysThe [Securities and Exchange] 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 issuersCh. 6 - Confidentiality - SOX - reporting up and out12Not later than 180 days after July 30, 2002Federal preemption despite protests from some state bar associationsThere has never been a challengeFederal intrusion into state area of traditional jurisdictionUndoubted constitutional power to govern terms of appearance before an agency- Defined VERY broadly in any way in the representation of issuers

13Reporting Under SOX Federal Preemption of RPCsChapter II--Securities and Exchange Commission Part 205--Standards of Professional Conduct for Attorneys Appearing and Practicing Before the Commission in the Representation of an IssuerCh. 6 - Confidentiality - SOX - reporting up and out131417 CFR 205.1 Purpose and scope.This part sets forth minimum standards of professional conduct for attorneys appearing and practicing before the Commission in the representation of an issuer. Ch. 6 - Confidentiality - SOX - reporting up and out14What does minimum standards mean?Reporting evidence or reporting knowledge which sets a higher standard Which is more burdensome to the attorneyAre state standards of duty to maintain the confidentiality of client communications higher? Or is it greater disclosure that is permitted to the states, less protective of client confidentiality? Which is more demanding of attorneys the duty to keep a secret or the duty to disclose?1517 CFR 205.1 Purpose and scope.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. Ch. 6 - Confidentiality - SOX - reporting up and out15What does minimum standards mean?Are state standards of duty to maintain the confidentiality of client communications higher? Or is it greater disclosure that is permitted to the states, less protective of client confidentiality? Which is more demanding of attorneys the duty to keep a secret or the duty to disclose?

1617 CFR 205.1 Purpose and scope [Preemption]Where the standards of a state or other United States jurisdiction where an attorney is admitted or practices conflict with this part, this part shall govern.Ch. 6 - Confidentiality - SOX - reporting up and out16To the extent that the SEC Regulations authorize but donot require revelation of client confidences and secretsunder certain circumstances, a Washington lawyershould not reveal such confidences and secrets unlessauthorized to do so under the RPCs.17Reporting UP - The SOX Triggering Event

Evidence of a Material Violation17 CFR 205.3 Issuer as clientCh. 6 - Confidentiality - SOX - reporting up and out171817 CFR 205.3 Issuer as client(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 to both the issuer's chief legal officer and its CEO.. forthwith. Compare: M.R. 1.13 (b)Ch. 6 - Confidentiality - SOX - reporting up and out18Providencia Amulex case: no material violation yet

(or the equivalent thereof) 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.Aware of evidence vs. knowledge(b) If a lawyer for an organization knows that an officer, employee or other person associatedwith the organization is engaged in action, intends to act or refuses to act in a matter related tothe representation that is a violation Refer to higher authority in stages

1917 CFR 205.2 Definitions(e) Evidence of a material violation 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 occurredis ongoing, or is about to occur.Ch. 6 - Confidentiality - SOX - reporting up and out19Providencia Amulet case is about to occurFirst duty is to prevent it.If that fails then have to report it upSuppose you did not read your email, or you just didnt get to responding and the statement is madeThen what? Now you have nowledge of a completed violation that has occurredDouble negativeIs the misstatement specific enough to be a violation?Would an investor reasonably rely upon it?(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.Appearing and Practicing before the commission 17 CFR 205.2(iii)Providing advice in respect of the United States securities laws or the Commission's rules or regulations thereunder regarding any document that theattorney has notice will be filed with or submitted to, or incorporated into any document that 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 documentCh. 6 - Confidentiality - SOX - reporting up and out20 205.2Definitions.For purposes of this part, the following definitions apply:(a)Appearing and practicingbefore the Commission:(1)Means:(i)Transacting any business with the Commission, including communications in any form;(ii)Representing anissuerin 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 theattorney has notice will be filed with or submitted to, or incorporated into any document that 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 anissueras 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 anattorneywho:(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 anissuerwith whom theattorneyhas anattorney-client relationship; or(ii)Is anon-appearing foreign attorney.

2021The Subordinate Attorneys Duty to Assess Reasonableness of the Chief Legal Officers ResponseCh. 6 - Confidentiality - SOX - reporting up and out212217 CFR 205.3 (b) (3) reporting upUnless an attorney who has made a report under paragraph (b)(1) reasonably believes that the chief legal officer or the chief executive officer of the issuer has provided an appropriate response within a reasonable time, the [subordinate] attorney shall report the evidence of a material violation to:Ch. 6 - Confidentiality - SOX - reporting up and out22* Burden on attorney to demonstrate reasonableness of response2317 CFR 205.3 (b) (3) up, and up(i) The audit committee of the issuer's board of directors;

(ii) Another committee of the issuer's [independent] board of directors consisting solely of directors who are not employed, directly or indirectly, by the issuer and are not..."interested persons"...(iii) The issuer's board of directors...Ch. 6 - Confidentiality - SOX - reporting up and out23Whats going on here?Are they dumping on young lawyers?2417 CFR 205.3 (b) (3) up, and up(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 CEO... under paragraph (b)(1) of this section, the attorney may report such evidence as provided under paragraph (b)(3) of this section.

Ch. 6 - Confidentiality - SOX - reporting up and out242517 CFR 205.2 Definitions - Appropriate ResponseCh. 6 - Confidentiality - SOX - reporting up and out2526Appropriate response(b) Appropriate response means a response as a result of which the attorney reasonably believes:

(1) That no material violation has occurred, is ongoing, or is about to occur;

(2) That the issuer has, as necessary, adopted appropriate remedial measuresCh. 6 - Confidentiality - SOX - reporting up and out2627Appropriate response- steps or sanctions to stop any material violations that are ongoing- to prevent any material violation that has yet to occur- to remedy or otherwise appropriately address any material violation that has already occurred-to minimize the likelihood of its recurrence; or

Ch. 6 - Confidentiality - SOX - reporting up and out2728Appropriate response Assigning Counsel(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 eitherCh. 6 - Confidentiality - SOX - reporting up and out2829Appropriate response Assigning Counsel(i) Has substantially implemented any remedial recommendations made by such attorney after a reasonable investigation and evaluation of the reported evidence; orCh. 6 - Confidentiality - SOX - reporting up and out2930Appropriate response Assigning Counsel(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, 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.Ch. 6 - Confidentiality - SOX - reporting up and out30Ch. 6 - Confidentiality - SOX - reporting up and outReporting to the SECReporting Out313117 CFR 205.3(2) An attorney appearing and practicing before the Commission in the representation of an issuer may reveal to the Commission, without the issuer's consent, confidential information related to the representation to the extent the attorney reasonably believes necessary:Ch. 6 - Confidentiality - SOX - reporting up and out323217 CFR 205.3(i) To prevent the issuer from committing a material violation that is likely to cause substantial injury to the financial interest or property of the issuer or investorsCh. 6 - Confidentiality - SOX - reporting up and out333317 CFR 205.3(ii) To prevent the issuer, in a Commission investigation or administrative proceeding from committing perjury, proscribed in 18 U.S.C. 1621; suborning perjury, proscribed in 18 U.S.C. 1622; or committing any act proscribed in 18 U.S.C. 1001 that is likely to perpetrate a fraud upon the Commission; or

(iii) To rectify the consequences of a material violation by the issuer that caused, or may cause, substantial injury to the financial interest or property of the issuer or investors in the furtherance of which the attorney's services were used.Ch. 6 - Confidentiality - SOX - reporting up and out3434Ch. 6 - Confidentiality - SOX - reporting up and outSarbanes Oxley preemptionA threat to federalism?35 FREE ENTERPRISE FUND ET AL. v. PUBLIC COM-PANY ACCOUNTING OVERSIGHT BOARD ET AL. CERTIORARI TO THE UNITED STATES COURT OF APPEALS FOR THE DISTRICT OF COLUMBIA CIRCUIT No. 08861. Argued December 7, 2009Decided June 28, 2010 Respondent, the Public Company Accounting Oversight Board, was created as part of a series of accounting reforms in the Sarbanes-Oxley Act of 2002. The Board is composed of five members appointed by the Securities and Exchange Commission. It was modeled on private self-regulatory organizations in the securities industrysuch as the New York Stock Exchangethat investigate and discipline their own members subject to Commission oversight.

Unlike these organizations, the Board is a Government-created entity with expansive powers to govern an entire industry. Every accounting firm that audits public companies under the securities laws must register withthe Board, pay it an annual fee, and comply with its rules and oversight. The Board may inspect registered firms, initiate formal investigations, and issue severe sanctions in its disciplinary proceedings. The parties agree that the Board is part of the Government for constitutional purposes, Lebron v. National Railroad Passenger Corporation, 513 U. S. 374, 397, and that its members are Officers of the United States who exercis[e] significant authority pursuant to the laws of the United States, Buckley v. Valeo, 424 U. S. 1, 125126 35ABA lauds state control in Dodd-Frank ActThe bill approved by the Conference Committee provides that the new Consumer Financial Protection Bureau may not exercise any supervisory or enforcement authority with respect to an activity engaged in by an attorney as part of the practice of law under the laws of a State in which the attorney is licensed to practice law.Ch. 6 - Confidentiality - SOX - reporting up and out36The American Bar Association and its nearly 400,000 membersindeed, all practicing lawyers in the United Statesare gratified that the House and Senate conferees on the financial markets reform legislation have recognized the importance of maintaining the historic role of state supreme courts regulatory authority over the practice of law.

Practicing lawyers are regulated under strict codes of professional conduct that are enforced at the state level, usually by state bar associations that exercise disciplinary authority delegated to them by state supreme courts. As officers of the court, lawyers are required to adhere to extensive regulations governing all aspects of the practice of law, and those who fail to comply are subject to severe penalties. There is no need for a federal layer of regulatory authority over these lawyers, as was first proposed in this legislation, and the ABA, along with state and local bars and our concerned members, has been diligent in engaging and assisting Congress on this subject. Our efforts have paid off.

The bill approved by the Conference Committee provides that the new Consumer Financial Protection Bureau may not exercise any supervisory or enforcement authority with respect to an activity engaged in by an attorney as part of the practice of law under the laws of a State in which the attorney is licensed to practice law.

The ABA is profoundly grateful to House Judiciary Committee Chairman John Conyers and Rep. Maxine Waters, who strongly advocated for respecting the interests of the state courts and the practicing lawyers licensed by those courts, while at the same time ensuring full protection for consumer interests. This was accomplished by tying the practice-of-law exclusion to the existence of an attorney-client relationship with the consumer client. Senate Banking Committee Chairman Chris Dodd and House Financial Services Chairman Barney Frank ultimately agreed with this perspective, we appreciate their sensitivity to retaining the traditional supervisory role of the states in regulating lawyers.3617 CFR 205.3 Reporting out(2) An attorney appearing and practicing before the Commission in the representation of an issuer may reveal to the Commission, without the issuer's consent, confidential information related to the representation to the extent the attorney reasonably believes necessary:Ch. 6 - Confidentiality - SOX - reporting up and out373717 CFR 205.3 Reporting out(i) To prevent the issuer from committing a material violation that is likely to cause substantial injury to the financial interest or property of the issuer or investorsCh. 6 - Confidentiality - SOX - reporting up and out383817 CFR 205.3 Reporting out(iii) To rectify the consequences of a material violation by the issuer that caused, or may cause, substantial injury to the financial interest or property of the issuer or investors in the furtherance of which the attorney's services were used.Ch. 6 - Confidentiality - SOX - reporting up and out3939Washington State Bar Proposed Formal Ethics OpinionSubsection (i) permits disclosure of a civil violation that does not rise to the level of a crime, but RPC 1.6 (b)(1) does not. Ch. 6 - Confidentiality - SOX - reporting up and out4040Washington State Bar Proposed Formal Ethics OpinionUnder subsection (iii), a material violation by the client which could damage financial interests or property of the client or investors could include non-criminal conduct which would also be barred from being revealed by RPC 1.6(b)(1).Ch. 6 - Confidentiality - SOX - reporting up and out4141Washington State Bar Proposed Formal Ethics OpinionIt is the opinion of the Board that, to the extent that this SEC regulation authorizes but does not require revelation of client's confidences and secrets, the Washington lawyer cannot reveal such confidences and secrets unless authorized to do so underthe Washington RPCs.Ch. 6 - Confidentiality - SOX - reporting up and out4242SEC rebukes Washington State Ethics OpinionIn opining that the Washington RPC 1.6 bars attorney disclosures permitted by Section 205.3(d)(2) of the Commission's rulesthe Proposed Interim Formal Opinion is inconsistent with prevailing Supreme Court precedent (which) has consistently upheld the authority of federal agencies to implement rules of conduct that diverge from and supersede state laws that address the same conduct.Ch. 6 - Confidentiality - SOX - reporting up and out4343