[Federal Register Volume 68, Number 25 (Thursday, February 6, 2003)]
[Rules and Regulations]
[Pages 6296-6323]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 03-2480]



[[Page 6295]]

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Part III





Securities and Exchange Commission





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17 CFR Parts 205, 240, and 249



Implementation of Standards of Professional Conduct for Attorneys; 
Final Rule and Proposed Rule

  Federal Register / Vol. 68, No. 25 / Thursday, February 6, 2003 / 
Rules and Regulations  

[[Page 6296]]


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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 205

[Release Nos. 33-8185; 34-47276; IC-25919; File No. S7-45-02]
RIN 3235-AI72


Implementation of Standards of Professional Conduct for Attorneys

AGENCY: Securities and Exchange Commission.

ACTION: Final rule.

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SUMMARY: The Securities and Exchange Commission (``Commission'') is 
adopting a final rule establishing standards of professional conduct 
for attorneys who appear and practice before the Commission on behalf 
of issuers. Section 307 of the Sarbanes-Oxley Act of 2002 requires the 
Commission to prescribe minimum standards of professional conduct for 
attorneys appearing and practicing before the Commission in any way in 
the representation of issuers. The standards must include a rule 
requiring an attorney to report evidence of a material violation of 
securities laws or breach of fiduciary duty or similar violation by the 
issuer up-the-ladder within the company to the chief legal counsel or 
the chief executive officer of the company (or the equivalent thereof); 
and, if they do not respond appropriately to the evidence, requiring 
the attorney to report the evidence to the audit committee, another 
committee of independent directors, or the full board of directors. 
Proposed Part 205 responds to this directive and is intended to protect 
investors and increase their confidence in public companies by ensuring 
that attorneys who work for those companies respond appropriately to 
evidence of material misconduct. We are still considering the ``noisy 
withdrawal'' provisions of our original proposal under section 307; in 
a related proposing release we discuss this part of the original 
proposal and seek comment on additional alternatives.

EFFECTIVE DATE: August 5, 2003.

FOR FURTHER INFORMATION CONTACT: Timothy N. McGarey or Edward C. 
Schweitzer at 202-942-0835.

I. Executive Summary

    Section 307 of the Sarbanes-Oxley Act of 2002 (the ``Act'') (15 
U.S.C. 7245)\1\ mandates that the Commission issue rules prescribing 
minimum standards of professional conduct for attorneys appearing and 
practicing before it in any way in the representation of issuers, 
including at a minimum a rule requiring an attorney to report evidence 
of a material violation of securities laws or breach of fiduciary duty 
or similar violation by the issuer or any agent thereof to appropriate 
officers within the issuer and, thereafter, to the highest authority 
within the issuer, if the initial report does not result in an 
appropriate response. The Act directs the Commission to issue these 
rules within 180 days.\2\
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    \1\ Section 307 of the Sarbanes-Oxley Act of 2002 (the ``Act'') 
(15 U.S.C. 7245) mandates that the Commission: Shall issue rights, 
in the public interest and for the protection of investors, setting 
forth minimum standards of professional conduct for attorneys 
appearing and practicing before the Commission in any way in the 
representation of issuers, including a rule--
    (1) Requiring an attorney to report evidence of a material 
violation of securities law or breach of fiduciary duty or similar 
violation by the company or any agent thereof, to the chief legal 
counsel or the chief executive officer of the company (or the 
equivalent thereof); and
    (2) If the counsel or officer does not appropriately respond to 
the evidence (adopting, as necessary, appropriate remedial measures 
or sanctions with respect to the violation), requiring the attorney 
to report the evidence to the audit committee of the board of 
directors of the issuer or to another committee of the board of 
directors comprised solely of directors not employed directly or 
indirectly by the issuer, or to the board of directors.
    \2\ President Bush signed the Act on July 30, 2002.
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    On November 21, 2002, in response to this directive, we published 
for comment proposed Part 205, entitled ``Standards of Professional 
Conduct for Attorneys Appearing and Practicing before the Commission in 
the Representation of an Issuer.'' The proposed rule prescribed minimum 
standards of professional conduct for attorneys appearing and 
practicing before us in any way in the representation of an issuer. The 
proposed rule took a broad view of who could be found to be appearing 
and practicing before us. It covered lawyers licensed in foreign 
jurisdictions, whether or not they were also admitted in the United 
States. In addition to a rigorous up-the-ladder reporting requirement, 
the proposed rule incorporated several corollary provisions. Under 
certain circumstances, these provisions permitted or required attorneys 
to effect a so-called ``noisy withdrawal'' by notifying the Commission 
that they have withdrawn from the representation of the issuer, and 
permitted attorneys to report evidence of material violations to the 
Commission.
    Our proposing release \3\ generated significant comment and 
extensive debate. We received a total of 167 timely comment letters: 
123 from domestic parties and 44 from foreign parties. In addition to 
soliciting comments, on December 17, 2002 the Commission hosted a 
Roundtable discussion concerning the impact of the rules upon foreign 
attorneys. Many of these comments focused on the following issues: The 
scope of the proposed rule (including, particularly, its application to 
attorneys who either are not admitted to practice in the United States, 
or are admitted in the United States but who do not practice in the 
field of securities law); the proposed rule's ``noisy withdrawal'' 
provision (including the Commission's authority to promulgate this 
portion of the rule and the provision's impact upon the attorney-client 
relationship); and the triggering standard for an attorney's duty to 
report evidence of wrongdoing. In light of the compressed time period 
resulting from the 180-day implementation deadline prescribed in the 
Act, a number of commenters requested that the Commission allow 
additional time for consideration of several aspects of the proposed 
rule, including the application of the rule to non-United States 
lawyers and the impact of the ``noisy withdrawal'' and related 
provisions.
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    \3\ See Release 33-8150 (Nov. 21, 2002), 67 FR 71669 (Dec. 2, 
2002).
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    The thoughtful and constructive suggestions we have received from a 
broad spectrum of commenters have enabled us better to understand 
interested parties' views concerning the operation and impact of the 
proposed rule. As more specifically discussed below, the final rule we 
adopt today has been significantly modified in light of these comments 
and suggestions. Thus, the triggering standard for reporting evidence 
of a material violation has been modified to clarify and confirm that 
an attorney's actions will be evaluated against an objective standard. 
The documentation requirements imposed upon attorneys and issuers under 
the proposed rule have been eliminated, and a ``safe harbor'' provision 
has been added to protect attorneys, law firms, issuers and officers 
and directors of issuers. In response to the large number of comments 
requesting that we defer the immediate implementation of a final rule 
to accord affected persons adequate time to assess the duties imposed 
thereunder, we have deferred the effective date of the rule until 180 
days after publication in the Federal Register.
    We believe that the final rule responds fully to the mandate of 
Section 307 to require reporting of evidence of material violations up-
the-ladder within an issuer, thereby allowing issuers to take necessary 
remedial action expeditiously and reduce any adverse

[[Page 6297]]

impact upon investors. The final rule strikes an appropriate balance 
between our initial rule proposal on up-the-ladder reporting and the 
various views expressed by commenters while still achieving this 
important goal.
    At the same time, the Commission considers it important to move 
forward in its assessment of rules under Section 307 requiring attorney 
withdrawal and notice to the Commission in cases where an issuer's 
officers and directors fail to respond appropriately to violations that 
threaten substantial injury to the issuer or investors. Accordingly, we 
are extending the comment period on the ``noisy withdrawal'' and 
related provisions of the proposed rule and are issuing a separate 
release soliciting comment on this issue. In that release, we are also 
proposing and soliciting comment on an alternative procedure to the 
``noisy withdrawal'' provisions. Under this proposed alternative, in 
the event that an attorney withdraws from representation of an issuer 
after failing to receive an appropriate response to reported evidence 
of a material violation, the issuer would be required to disclose its 
counsel's withdrawal to the Commission as a material event. In the same 
release, we are soliciting additional comment on the final rules we are 
adopting, particularly insofar as adoption of the ``noisy withdrawal'' 
provisions of the proposed alternative might require conforming changes 
to the final rule.
    Interested parties should submit comments within 60 days of the 
date of publication of the proposing release in the Federal Register. 
This will provide additional time for interested parties to comment on 
the impact of these provisions while still allowing for their 
implementation as of the effective date of the final rule.

II. Section-by-Section Discussion of the Final Rule

Section 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. 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. 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.
    Proposed Section 205.1 stated that this part will govern ``[w]here 
the standards of a state where an attorney is admitted or practices 
conflict with this part.'' In the proposing release, we specifically 
raised the question whether this part should ``preempt conflicting 
state ethical rules which impose a lower obligation'' upon 
attorneys.\4\
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    \4\ 67 FR 71670, 71697 (Dec. 2, 2002).
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    A number of commenters questioned the Commission's authority to 
preempt state ethics rules, at least without being explicitly 
authorized and directed to do so by Congress.\5\ Another comment letter 
noted that the Constitution's Commerce Clause grants the federal 
government the power to regulate the securities industry, that the 
Sarbanes-Oxley Act requires the Commission to establish rules setting 
forth minimum standards of conduct for attorneys appearing and 
practicing before it, and that, under the Supremacy Clause, duly 
adopted Commission rules will preempt conflicting state rules.\6\ 
Finally, several commenters questioned why the Commission would seek to 
supplant state ethical rules which impose a higher obligation upon 
attorneys.\7\
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    \5\ See Comments of the Association of the Bar of the City of 
New York, at 28 (``There is nothing in Section 307 to suggest that 
Congress authorized the Commission to preempt state law and rules 
governing attorney conduct.''); see also Comments of the American 
Bar Association, at 32; Comments of 77 law firms, at 2. While 
questioning the Commission's authority in this area, the American 
Bar Association (``ABA'') nevertheless recognized that ``the federal 
system of the United States may provide an arguable basis for the 
pre-emption of attorney-client and confidentiality obligations 
applicable to United States attorneys.'' See Comments of the 
American Bar Association, at 37.
    \6\ See Comments of Susan P. Koniak et al., at 28-29.
    \7\ See, e.g., Comments of Susan P. Koniak et al., at 32; 
Comments of Richard W. Painter, at 8; Comments of Nancy J. Moore, at 
3.
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    The language which we adopt today clarifies that this part does not 
preempt ethical rules in United States jurisdictions that establish 
more rigorous obligations than imposed by this part. At the same time, 
the Commission reaffirms that its rules shall prevail over any 
conflicting or inconsistent laws of a state or other United States 
jurisdiction in which an attorney is admitted or practices.

Section 205.2--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 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.

    The definition of the term ``appearing and practicing'' included in 
the proposed rule was based upon Rule 102(f) of our Rules of Practice, 
and covered, inter alia, an attorney's advising a client (1) that a 
statement, opinion, or other writing does not need to be filed with or 
incorporated into any type of submission to the Commission or its 
staff, or (2) that the issuer is not required to submit or file any 
registration statement, notification, application, report, 
communication or other document with the Commission or its staff. This 
broad definition was intended to reflect the reality that materials 
filed with the Commission frequently contain information contributed, 
edited or prepared by individuals who are not necessarily responsible 
for the actual filing of the materials, and was consistent with the 
position the Commission has taken as amicus curiae in cases involving 
liability under Section 10(b) of the Exchange Act (15 U.S.C. 78j(b)).
    A number of commenters argued that the proposed definition of 
``appearing and practicing'' was overly broad. The American Bar 
Association (``ABA'') stated that the definition in the proposed rule 
would unfairly:

subject to the rules attorneys who do not practice securities law 
and may have only limited or tangential involvement with particular 
SEC filings and documents. For example, it could inappropriately 
encompass non-securities 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 that may be used for that purpose,

[[Page 6298]]

and lawyers preparing documents that eventually may be filed as 
exhibits. * * * We also believe it is inappropriate for the 
Commission to include lawyers who simply advise on the availability 
of exemptions from registration.\8\
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    \8\ See Comments of the American Bar Association, at 12.

The ABA recommended that the definition be modified to apply ``only to 
those lawyers with significant responsibility for the company's 
compliance with United States securities law, including satisfaction of 
registration, filing and disclosure obligations, or with overall 
responsibility for advising on legal compliance and corporate 
governance matters under United States law.'' \9\
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    \9\ Id.; see also Comments of Sullivan & Cromwell, at 12-14; 
Comments of 77 law firms, at 7 (arguing that the scope of the 
definition of the term may incite efforts by attorneys to limit 
their involvement in certain matters in an effort to avoid coming 
within the purview of the rule).
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    On the other hand, several commenters supported the more expansive 
definition set forth in the proposed rule. A comment letter submitted 
by a group of 50 academics specifically affirmed their:

support [for] the Commission's inclusion of lawyers who advise and/
or draft, but do not sign, documents filed with the Commission, as 
well as lawyers who advise that documents need not be filed with the 
Commission. Any other rule would facilitate circumvention of these 
rules by encouraging corporate managers and corporate counsel to 
confine lawyer signatures on Commission documents or filings to a 
bare minimum to ensure no up-the-ladder reporting of wrongdoing. 
That would risk gutting these rules and Sec.  307.\10\
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    \10\ See Comments on Susan P., Koniak et al., at 33.

    The definition contained in the final rule addresses several of the 
concerns raised by commenters. Attorneys who advise that, under the 
federal securities laws, a particular document need not be incorporated 
into a filing, registration statement or other submission to the 
Commission will be covered by the revised definition. In addition, an 
attorney must have notice that a document he or she is 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 in the final rule thereby also clarifies that an attorney's 
preparation of a document (such as a contract) which he or she never 
intended 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.
    As discussed below, commenters also raised concerns regarding the 
potential application of the rule to attorneys who, while admitted to 
practice in a state or other United States jurisdiction, were not 
providing legal services to an issuer. Under the final rule, attorneys 
need not serve in the legal department of an issuer to be covered by 
the final rule, but they must be providing legal services to an issuer 
within the context of an attorney-client relationship. An attorney-
client relationship may exist even in the absence of a formal retainer 
or other agreement. Moreover, in some cases, an attorney and an issuer 
may have an attorney-client relationship within the meaning of the rule 
even though the attorney-client privilege would not be available with 
respect to communications between the attorney and the issuer.
    The Commission intends that the issue whether an attorney-client 
relationship exists for purposes of this part will be a federal 
question and, in general, will turn on the expectations and 
understandings between the attorney and the issuer. Thus, whether the 
provision of legal services under particular circumstances would or 
would not establish an attorney-client relationship under the state 
laws or ethics codes of the state where the attorney practices or is 
admitted may be relevant to, but will not be controlling on, the issue 
under this part. This portion of the definition will also have the 
effect of excluding from coverage attorneys at public broker-dealers 
and other issuers who are licensed to practice law and who may transact 
business with the Commission, but who are not in the legal department 
and do not provide legal services within the context of an attorney-
client relationship. Non-appearing foreign attorneys, as defined below, 
also are not covered by this definition.
    205.2(b) provides:

    (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 Sec.  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, 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.

    The definition of ``appropriate response'' emphasizes that an 
attorney's evaluation of, and the appropriateness of an issuer's 
response to, evidence of material violations will be measured against a 
reasonableness standard. The Commission's intent is to permit attorneys 
to exercise their judgment as to whether a response to a report is 
appropriate, so long as their determination of what is an ``appropriate 
response'' is reasonable.
    Many of the comments on this paragraph focused on the proposal's 
standard that an attorney has received an appropriate response when the 
attorney ``reasonably believes,'' based on the issuer's response, that 
there either is or was no material violation, or that the issuer has 
adopted appropriate remedial measures. They suggested, among other 
things, that the paragraph be amended to state that the attorney could 
rely upon the factual representations and legal determinations that a 
reasonable attorney would rely upon,\11\ or that the Commission adopt 
the ABA's Model Rules' definition of ``reasonably believes.''\12\ 
Others opined that the

[[Page 6299]]

``reasonably believes'' standard was inappropriate because it would 
impose on lawyers who are not expert in the securities laws a standard 
based on the ``reasonable'' securities law expert.\13\ Others opined 
that the standard should be modified to require the lawyer's ``actual 
understanding,'' rather than reasonable belief, regarding a ``clear'' 
material violation,\14\ while others urged that the standard must be 
objective.\15\
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    \11\ Comments of Thomas D. Morgan, at 5-6; Comments of Morrison 
& Foerster and eight other law firms, at 14 (paragraph 205.2(b) 
should be revised to read that in all situations it would be an 
appropriate response for an issuer to assert a colorable defense to 
any claim of material violation).
    \12\ Comments of Palmer & Dodge, Attachment at 2 (``The Model 
Rules state that `reasonable belief' or `reasonably believes' when 
used in reference to a lawyer denotes that the lawyer believes the 
matter in question and that the circumstances are such that the 
belief is reasonable.'' Model Rule 1.0(i)). ``Reasonable'' and 
``reasonably,'' in turn, are defined as ``denot[ing] the conduct of 
a reasonably prudent and competent lawyer.'' Model Rule 1.0(h). 
Along similar lines, one group of commenters suggested that the 
paragraph include language paralleling the Model Rule definition, 
setting as the standard the conclusion of ``a prudent and competent 
attorney, acting reasonably under the same circumstances'' that a 
response was appropriate. Comments of Susan P. Koniak et al., at 12-
13, 15; see also Comments of the SIA/TBMA, at 18 (urging that the 
Commission modify this paragraph to protect an attorney whose 
judgment that an issuer's response was appropriate was ``reasonable 
under the circumstances'').
    \13\ Comments of the American Corporate Counsel Association, at 
10. This concern was also expressed by commenters who asserted that 
foreign lawyers, in particular, would not have sufficient practical 
knowledge of United States laws to determine what constitutes an 
appropriate response. See, e.g., Comments of Nagashima Ohno & 
Tsunematsu, at 7; Comments of the SIA/TBMA, at 13 (reporting 
attorney's judgment should be evaluated in light of that attorney's 
training, experience and position).
    \14\ Comments of Covington & Burling, at 3.
    \15\ Comments of Susan P. Koniak et al., at 12-13.
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    Other commenters felt that the paragraph did not properly address 
situations, which the commenters felt would be frequent, where an 
issuer's inquiry into the report of a possible material violation would 
be ``inconclusive.''\16\ Others expressed the belief that the rule did 
not give a reporting lawyer sufficient guidance ``such that a reporting 
attorney can with confidence, and without speculation, determine 
whether he or she has received an appropriate response.''\17\ Some 
comments questioned whether reporting attorneys would be able to judge 
whether discipline or corrective measures were sufficient to constitute 
an appropriate response.\18\ One suggested that the paragraph be 
modified to provide that an attorney has received an appropriate 
response when the chief legal officer (``CLO'') states that he or she 
has fulfilled the obligations set forth in Section 205.3(b)(3), unless 
the attorney is reasonably certain that the representations are 
untrue.\19\ Some commenters found the term ``and/or'' in subparagraph 
(b)(2) of the proposed paragraph confusing.\20\ Others questioned 
whether the provision that the issuer ``rectify'' the material 
violation should be read to contemplate restitution to injured parties, 
with one stating that it did not believe Congress intended to impose 
upon attorneys an obligation to require issuers to make 
restitution,\21\ while others read the proposed rule as ``impl[ying] 
that the appropriateness of a response need not include compensation of 
injured parties,'' and accordingly supported this standard.\22\ A few 
commenters noted that under subparagraph (b)(2) a response is 
appropriate only if the issuer has already ``adopted remedial 
measures,'' and thus apparently does not apply if the issuer is in the 
process of adopting them. They urged that the Commission provide that 
an appropriate response includes ongoing remedial measures.\23\
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    \16\ Comments of Covington & Burling, at 3.
    \17\ Comments of Richard Hall, Cravath Swaine & Moore, at 6-7; 
Comments of the Association of the Bar of the City of New York, at 
12; Comments of Carter, Ledyard & Milburn, at 3 (stating that 
requiring an attorney, in deciding whether an issuer has made an 
appropriate response, to determine whether a material violation is 
about to occur, is an ``impossibly predictive standard''); Comments 
of the Japan Federation of Bar Associations, at 3 (opining that the 
term ``appropriate response'' cannot be easily construed on its 
face).
    \18\ Comments of the SIA/TBMA, at 18; Comments of the 
Association of the Bar of the City of New York, at 12 (``[o]nce an 
attorney has reported and documented a possible violation, the 
attorney should be assured that good faith reliance upon the 
response protects the attorney).
    \19\ Comments of the Corporation, Finance and Securities Law 
Section of the District of Columbia Bar, at 14; Comments of the 
American Bar Association, at 22 (``[w]e believe it is important that 
the Commission recognize that a reporting attorney may rely on the 
considered judgment of the CLO so long as that judgment is in the 
range of reasonableness even though the attorney would not 
necessarily come out that way''); Comments of Skadden, Arps, Slate, 
Meagher & Flom, at 9-10 (reporting attorney should be able to rely 
upon the stated belief of the officer to whom he has reported the 
evidence of material violation that no material violation has 
occurred).
    \20\ Comments of JP Morgan & Chase, at 10-11; Comments of 
Debevoise & Plimpton, at 5.
    \21\ Comments of JP Morgan & Chase, at 11; Comments of Debevoise 
& Plimpton, at 5-6.
    \22\ Comments of the Corporation, Finance and Securities Law 
Section of the District of Columbia Bar, at 14.
    \23\ Comments of Carter, Ledyard & Milburn, at 3; Comments of 
Skadden, Arps, Slate, Meagher & Flom, at 9-10 (appropriate response 
should include a timely response that adequate measures are being 
taken).
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    A few comments were directed at the discussion accompanying the 
proposed rule. One suggestion was that the Commission make clear that 
the factors it will consider in determining whether an outside law 
firm's response that no violation has occurred constitutes an 
appropriate response include a description of the scope of the 
investigation undertaken by the law firm and the relationship between 
the issuer and the firm. They also urged the Commission to expressly 
state that the greater or more credible the evidence that triggered the 
report, the more detailed an investigation into the matter must be.\24\ 
One commenter also suggested that the Commission withdraw the statement 
in the release of the proposed rule that Section 205.2(b) ``permits'' 
attorneys ``to exercise their judgment,'' finding that language both 
superfluous and conveying a signal that the Commission will be loathe 
to second-guess a lawyer's judgment that a response is ``appropriate.'' 
\25\
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    \24\ Comments of Susan P. Koniak et al., at 13; Comments of 
Schiff Hardin & Waite, at 4-5 (criticizing the examples in the 
release of the proposed rule as undercutting the proposition that 
attorneys will be permitted to exercise their reasonable judgment, 
and stating that the Commission should clarify that the 
reasonableness of an issuer's response will vary depending on the 
circumstances and will not necessarily depend on the existence of a 
written legal opinion from outside counsel to the issuer); Comments 
of the SIA/TBMA, at 18 (suggesting revisions to Section 205.2(b) 
that would state that an appropriate response should be reasonable 
under the circumstances, measured by the magnitude and quality of 
the evidence of the violation, the severity of the violation, and 
whether there is a potential for ongoing or recurring violation).
    \25\ Comments of Susan P. Koniak et al., at 12.
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    Several commenters suggested that the proposed rule should exempt 
internal investigations of reported evidence of a material 
violation.\26\ Commenters were concerned that the reporting and 
disclosure requirements in the proposed rules might discourage issuers 
from obtaining legal advice and undertaking internal investigations and 
that, as a result, some violations might not be discovered or 
resolved.\27\ Thus, some commenters urged that an issuer must be 
permitted ``to retain counsel to investigate the claim and respond to 
it, including defense in litigation, without being at risk of violating 
the rule.''\28\ Some commenters stated that ``counsel conducting an 
internal investigation'' should not be subject to the rule's reporting 
and disclosure requirements.\29\
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    \26\ Comments of the SIA/TBMA, at 11 (stating that the Rules 
``should exempt outside counsel whom securities firms retain to 
conduct internal investigations'').
    \27\ Comments of Carter, Ledyard & Milburn, at 6 (noting risk 
that proposed rules ``might discourage persons from seeking legal 
representation''); Comments of the SIA/TBMA, at 11.
    \28\ Comments of Weil Gotshal & Manges, at 7.
    \29\ Comments of the Corporation, Finance and Securities Law 
Section of the District of Columbia Bar, at 4; Comments of the 
American Bar Association, at 30.
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    The proposing release stated that ``[i]t would not be an 
inappropriate response to reported evidence of a material violation for 
an issuer's CLO to direct defense counsel to assert either a colorable 
defense or a colorable basis for contending that the staff should not 
prevail. Such directions from the CLO, therefore, would not require 
defense counsel to report any evidence of a material violation to the 
issuer's directors.''\30\ Several commenters were concerned over a 
possible chilling effect on an attorney's representation of an issuer 
in a Commission investigation or administrative proceeding if the 
attorney were subject to reporting and disclosure requirements.\31\ 
Some noted

[[Page 6300]]

that an issuer's disagreement in good faith with the Commission over a 
matter in litigation should not raise a reporting obligation under the 
rules.\32\ Others suggested that the definition of ``appropriate 
response'' include the assertion of ``a colorable defense or the 
obligation of the Commission staff to bear the burden of proving its 
case.'' \33\ Some commenters stressed that an attorney representing an 
issuer should be able to take any position for which there is an 
evidentiary foundation and a nonfrivolous legal basis.\34\ The 
commenters did not want the final rules to impair an advocate's ability 
to present non-frivolous arguments. Some commenters noted that an 
issuer has no right to use an attorney to conceal ongoing violations or 
plan further violations of the law.\35\
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    \30\ 67 FR 71683.
    \31\ Comments of Akin Gump Strauss Hauer & Feld, at 7-8; 
Comments of Cleary, Gottlieb, Steen & Hamilton, at 9 (``There would 
be an unavoidable chilling effect on the advocacy of lawyers who 
represent clients before the Commission in investigations and 
administrative proceedings if Rule 205 applies to them.''); Comments 
of the Association of the Bar of the City of New York, at 19-20 
(stating that it would be ``unfair[] to include attorneys who are 
adverse parties in enforcement or administrative proceedings within 
the reporting and withdrawal requirements of the proposed rules''); 
Comments of Susan P. Koniak et al., at 36 (final rules should 
``avoid chilling legitimate and vigorous advocacy'').
    \32\ Comments of Richard Hall, Cravath, Swaine & Moore, at 3.
    \33\ Comments of Morrison & Foerster and eight other law firms, 
at 14.
    \34\ Comments of Securities Regulation Committee, Business Law 
Section, New York State Bar Association, at 6 (stating that ``a 
lawyer need not subjectively believe that he or she has the 'better 
side of the argument' or that it is a position likely to prevail. 
The attorney is permitted to undertake the representation if he or 
she, after a reasonable investigation, believes that there is (or 
will be) evidentiary support for the position and that the 
assertions of law are nonfrivolous. See, e.g., Rule 11, Fed. R. Civ. 
P.''). See also Comments of Cleary, Gottlieb, Steen & Hamilton, at 9 
(``Lawyers representing clients before the Commission must be free 
to make all non-frivolous arguments to the staff.'').
    \35\ Comments of Susan P. Koniak, et al., at 37.
---------------------------------------------------------------------------

    The standard set forth in the final version of Section 205.2(b) 
requires the attorney to ``reasonably believe'' either that there is no 
material violation or that the issuer has taken proper remedial steps. 
The term ``reasonably believes'' is defined in Section 205.2(m). In 
providing that the attorney's belief that a response was appropriate be 
reasonable, the Commission is allowing the attorney to take into 
account, and the Commission to weigh, all attendant circumstances. The 
circumstances a reporting attorney might weigh in assessing whether he 
or she could reasonably believe that an issuer's response was 
appropriate would include the amount and weight of the evidence of a 
material violation, the severity of the apparent material violation and 
the scope of the investigation into the report. While some commenters 
suggested that a reporting attorney should be able to rely completely 
on the assurance of an issuer's CLO that there was no material 
violation or that the issuer was undertaking an appropriate response, 
the Commission believes that this information, while certainly relevant 
to the determination whether an attorney could reasonably believe that 
a response was appropriate, cannot be dispositive of the issue. 
Otherwise, an issuer could simply have its CLO reply to the reporting 
attorney that ``there is no material violation,'' without taking any 
steps to investigate and/or remedy material violations. Such a result 
would clearly be contrary to Congress' intent in enacting Section 307. 
On the other hand, it is anticipated that an attorney, in determining 
whether a response is appropriate, may rely on reasonable and 
appropriate factual representations and legal determinations of persons 
on whom a reasonable attorney would rely.
    Some commenters expressed confusion over the ``and/or'' connectors 
in the proposed subparagraph (b)(2), and they have been eliminated in 
the final rule. The Commission believes that the revisions to this 
subparagraph make clear that the issuer must adopt appropriate remedial 
measures or sanctions to prevent future violations, redress past 
violations, and stop ongoing violations and consider the feasibility of 
restitution. The concern that under subparagraph (b)(2) any issuer's 
response to a reporting attorney that remedial measures are ongoing but 
not completed must be deemed to be inappropriate, thereby requiring 
reporting up-the-ladder, appears to be overstated. Many remedial 
measures, such as disclosures and the cessation of ongoing material 
violations, will occur in short order once the decision has been made 
to pursue them. Beyond this, the reasonable time period after which a 
reporting attorney is obligated to report further up-the-ladder would 
include a reasonable period of time for the issuer to complete its 
ongoing remediation.
    By broadening the definition of ``appropriate response,'' 
subparagraph (b)(3) responds to a variety of concerns raised by 
commenters. Subparagraph (b)(3) permits an issuer to assert as an 
appropriate response that it has directed its attorney, whether 
employed or retained by it, to undertake an internal review of reported 
evidence of a material violation and has substantially implemented the 
recommendations made by an attorney after reasonable investigation and 
evaluation of the reported evidence. However, the attorney retained or 
directed to conduct the evaluation must have been retained or directed 
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.
    Subparagraph (b)(3) also explicitly incorporates into the final 
rule our view, expressed in the proposing release, that ``[i]t would 
not be an inappropriate response to reported evidence of a material 
violation for an issuer's CLO to direct defense counsel to assert 
either a colorable defense or a colorable basis for contending that the 
staff should not prevail.''\36\ Subparagraph (b)(3) incorporates this 
standard into the definition of ``appropriate response'' by permitting 
an issuer to respond to a report that it has been advised by its 
attorney that he or she may assert a colorable defense on behalf of the 
issuer in response to the reported evidence ``in any investigation or 
judicial or administrative proceeding,'' including by asserting a 
colorable basis that the Commission or other charging party should not 
prevail.\37\ The provision would apply only where the defense could be 
asserted consistent with an attorney's professional obligation. Once 
again, the attorney opining that he or she may assert a colorable 
defense must have been retained or directed to evaluate the matter with 
the consent of the issuer's board of directors, a committee thereunder 
to whom a report could be made pursuant to Section 205(b)(3), or a 
qualified legal compliance committee.
---------------------------------------------------------------------------

    \36\ The text of the final rule does not specifically include a 
reference to a ``colorable basis for contending that the staff [or 
other litigant] should not prevail,'' nor does it specifically refer 
to requiring the Commission staff or other litigant to bear the 
burden of its case. The Commission, however, considers these and 
related actions permitted to an attorney, consistent with his or her 
professional obligations, to be included within the reference to 
asserting a ``colorable defense.''
    \37\ Subparagraph (b)(3) thereby also addresses the concern of 
some commenters that an attorney representing an issuer in 
connection with a Commission investigation or administrative 
proceeding not be required to report the information. Under 
subparagraph (b)(3), asserting a colorable defense on an issuer's 
behalf in an investigation or administrative proceeding may 
constitute an appropriate response, and no further reporting would 
be required.
---------------------------------------------------------------------------

    We noted in our proposing release our intention that the rule not 
``impair zealous advocacy, which is essential to the Commission's 
processes.''\38\ The attorney conducting an internal investigation that 
is contemplated under subparagraph (b)(3) may engage in full and frank 
exchanges of information with the issuer he or she represents.

[[Page 6301]]

Moreover, as noted above, subparagraph (b)(3) expressly provides that 
the assertion of colorable defenses in an investigation or judicial or 
administrative proceeding is an appropriate response to reported 
evidence of a material violation. Concerns over a chilling effect on 
advocacy should thus be allayed. At the same time, by including a 
requirement that this response be undertaken with the consent of the 
issuer's board of directors, or an appropriate committee thereof, the 
revised definition is intended to protect against the possibility that 
a chief legal officer would avoid further reporting ``up-the-ladder'' 
by merely retaining a new attorney to investigate so as to assert a 
colorable, but perhaps weak, defense.
---------------------------------------------------------------------------

    \38\ 67 FR 71673.
---------------------------------------------------------------------------

    The term ``colorable defense'' does not encompass all defenses, but 
rather is intended to incorporate standards governing the positions 
that an attorney appropriately may take before the tribunal before whom 
he or she is practicing. For example, in Commission administrative 
proceedings, existing Rule of Practice 153(b)(1)(ii), 17 CFR 
201.153(b)(1)(ii), provides that by signing a filing with the 
Commission, the attorney certifies that ``to the best of his or her 
knowledge, information, and belief, formed after reasonable inquiry, 
the filing is well grounded in fact and is warranted by existing law or 
a good faith argument for the extension, modification, or reversal of 
existing law.'' An issuer's right to counsel is thus not impaired where 
the attorney is restricted to presenting colorable defenses, including 
by requiring the Commission staff to bear the burden of proving its 
case. Of course, as some commenters noted, an issuer has no right to 
use an attorney to conceal ongoing violations or plan further 
violations of the law.
    205.2(c) provides:

    (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.

    Commenters suggested that the proposed rule's definition of the 
term ``attorney'' was unnecessarily broad. A number of commenters 
suggested that it was inappropriate to apply the rule to foreign 
attorneys, arguing that foreign attorneys, and attorneys representing 
or employed by multijurisdictional firms, are subject to statutes, 
rules, and ethical standards in those foreign jurisdictions that are 
different from, and potentially incompatible with, the requirements of 
this rule.\39\ These points were amplified by foreign attorneys who 
attended a December 17, 2002 Roundtable discussion hosted by the 
Commission to address the issues raised by the application of the rule 
to foreign attorneys.
---------------------------------------------------------------------------

    \39\ See, e.g., Comments of Skadden, Arps, Slate, Meagher and 
Flom, at 16 (noting that foreign private issuers usually consult 
with United States counsel on securities matters, and suggesting 
that limiting the definition of ``attorney'' to lawyers licensed in 
United States jurisdictions ``will avoid the unfairness of 
subjecting foreign lawyers to the Proposed Rules without 
compromising the effectiveness of the rules.'').
---------------------------------------------------------------------------

    As noted above, and as set forth more fully below, the rule we 
adopt today adds a new defined term, ``non-appearing foreign 
attorney,'' which addresses many of the concerns expressed regarding 
the application of the rule to foreign attorneys. In addition, other 
commenters argued that the proposed rule's definition of ``attorney'' 
applied to a large number of individuals employed by issuers who are 
admitted to practice, but who do not serve in a legal capacity. By 
significantly narrowing the definition of the term ``appearing and 
practicing'' as set forth above, we have addressed many of the concerns 
expressed by commenters concerning the application of the rule to 
individuals admitted to practice who are employed in non-legal 
positions and do not provide legal services.
    205.2(d) provides:

    (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.

    The definition we adopt today has been slightly modified from the 
definition included in the proposing release. Several commenters 
suggested that the definition in the proposing release should be 
amended to include breaches of fiduciary duty arising under federal or 
state statutes.\40\ The phrase ``under an applicable federal or state 
statute'' has been added to clarify that breaches of fiduciary duties 
imposed by federal and state statutes are covered by the rule.
---------------------------------------------------------------------------

    \40\ See Comments of Richard W. Painter, at 10-11 (``Breaches of 
fiduciary duty to pension funds under federal law such as ERISA, and 
other similar violations would thus clearly be covered, whereas 
arguably they are not under the current definition in the Proposed 
Rules.'').
---------------------------------------------------------------------------

    205.2(e) provides:

    (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 revised definition of ``evidence of a material violation'' 
clarifies aspects of the objective standard that the Commission sought 
to achieve in the definition originally proposed.\41\ The definition of 
``evidence of a material violation'' originally proposed prompted 
extensive comment because (read together with the rule's other 
definitions) it defines the trigger for an attorney's obligation under 
the rule to report up-the-ladder to an issuer's CLO or qualified legal 
compliance committee (``QLCC'') (in section 205.3(b)). Some commenters, 
including some practicing attorneys, found the proposed reporting 
trigger too high.\42\ Many legal scholars endorsed the framework of 
increasingly higher triggers for reporting proposed by the Commission 
at successive stages in the reporting process but considered the 
Commission's attempt at articulating an objective standard unworkable 
and suggested changes to the language in the proposed rule.\43\ Nearly 
all practicing lawyers who commented found the reporting trigger in the 
rule too low and called instead for a subjective standard, requiring 
``actual belief'' that a material violation has occurred, is ongoing, 
or is about to occur before the attorney would be obligated to make an 
initial report within the client issuer.\44\ The revised

[[Page 6302]]

definition incorporates suggested changes into an objective standard 
that is designed to facilitate the effective operation of the rule and 
to encourage the reporting of evidence of material violations.
---------------------------------------------------------------------------

    \41\ The proposed rule defines 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'' and reasonable belief as what ``an attorney, acting 
reasonably, would believe.''
    \42\ E.g., Comments of John Bullock, at 1 (``the threshold for 
mandatory reporting by an attorney should be the level of evidence 
that a responsible corporate officer should want to know, so that 
the client can pursue an investigation and take appropriate action. 
The standard should therefore be 'some credible information that a 
material violation may have occurred, may be occurring, or may be 
about to occur.''').
    \43\ Comments of Richard W. Painter, at 6 (suggesting that 
``evidence that a violation is `possible' could trigger the duty to 
report to the Chief Legal Officer, whereas evidence that a violation 
is ``likely'' could trigger the duty to report to the full board or 
to the QLCC. Evidence that a violation was `highly likely' or a 
`near certainty' could trigger the requirement of a noisy 
withdrawal.''); Comments of Susan P. Koniak et al., at 9-11, 15-17 
(emphasizing the importance of distinguishing between a violation 
and evidence of one and suggesting the use of the phrase ``credible 
evidence'').
    \44\ Comments of Skadden Arps, Slate, Meagher & Flom, at 10 
(proposing to define ``evidence of a material violation'' as ``facts 
and circumstances known to an attorney which have caused the 
attorney to believe that a material violation has occurred, is 
occurring or is about to occur''); Comments of Chadbourne & Parke, 
at 7 (proposing ``a subjective standard that an attorney 
`knows[rs'quo] that a material violation has occurred, is occurring 
or is about to occur''); Comments of Sullivan & Cromwell, at 11 
(``Evidence of a material violation means information of which the 
attorney is consciously aware that would, in the attorney's 
judgment, constitute a material violation that has occurred, is 
occurring, or is about to occur.''); Comments of the American Bar 
Association, at 17 (recommending use of ``the knowledge standard'').
---------------------------------------------------------------------------

    Evidence of a material violation must first be credible 
evidence.\45\ An attorney is obligated to report when, based upon that 
credible evidence, ``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 formulation, while intended to adopt an 
objective standard, also recognizes that there is a range of conduct in 
which an attorney may engage without being unreasonable.\46\ The 
``circumstances'' are the circumstances at the time the attorney 
decides whether he or she is obligated to report the information. These 
circumstances may include, among others, the attorney's professional 
skills, background and experience, the time constraints under which the 
attorney is acting, the attorney's previous experience and familiarity 
with the client, and the availability of other lawyers with whom the 
lawyer may consult. Under the revised definition, an attorney is not 
required (or expected) to report ``gossip, hearsay, [or] innuendo.'' 
\47\ Nor is the rule's reporting obligation triggered by ``a 
combination of circumstances from which the attorney, in retrospect, 
should have drawn an inference,'' as one commenter feared.
---------------------------------------------------------------------------

    \45\ See Comments of Susan P. Koniak et al., at 18.
    \46\ Comments of Richard W. Painter, at 5-6.
    \47\ Comments of the Association of the Bar of the City of New 
York, at 10.
---------------------------------------------------------------------------

    On the other hand, the rule's definition of ``evidence of a 
material violation'' makes clear that the initial duty to report up-
the-ladder is not triggered only when the attorney ``knows'' that a 
material violation has occurred \48\ or when the attorney ``conclude[s] 
there has been a violation, and no reasonable fact finder could 
conclude otherwise.''\49\ That threshold for initial reporting within 
the issuer is too high. Under the Commission's rule, evidence of a 
material violation must be reported in all circumstances in which it 
would be unreasonable 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. To be ``reasonably likely'' 
a material violation must be more than a mere possibility, but it need 
not be ``more likely than not.''\50\ If a material violation is 
reasonably likely, an attorney must report evidence of this violation. 
The term ``reasonably likely'' qualifies each of the three instances 
when a report must be made. Thus, a report is required when it is 
reasonably likely a violation has occurred, when it is reasonably 
likely a violation is ongoing or when reasonably likely a violation is 
about to occur.
---------------------------------------------------------------------------

    \48\ The standard was suggested, e.g., in Comments of the 
American Bar Association, at 5, 16-17.
    \49\ Comments of Cleary, Gottlieb, Steen & Hamilton, at 5-6 (any 
lower trigger for reporting would be equivocal, would lead to 
disparate application of the rule, and would ``chill'' the attorney-
client relationship).
    \50\ The Commission intends the definition of the term 
``reasonably likely'' to be consistent with the discussion of the 
term included in the adopting release for the recently adopted final 
rule governing disclosure of off-balance sheet arrangements, enacted 
pursuant to Sec.  401(a) of the Sarbanes-Oxley Act.
---------------------------------------------------------------------------

    205.2(f) provides:

    (f) Foreign government issuer means a foreign issuer as defined 
in 17 CFR 230.405 eligible to register securities on Schedule B of 
the Securities Act of 1933 (15 U.S.C. 77a et seq., Schedule B).

    We adopt the definition for this new term prescribed under Rule 
405.
    205.2(g) provides:

    (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.

    The definition we adopt today has been modified from the definition 
included in the proposing release. The phrase ``providing legal 
services'' has been substituted for the term ``acting.'' Some 
commenters objected that the term ``acting'' was both imprecise and 
overly broad, and that the concept of ``representation of an issuer'' 
should ``apply only to attorneys who are rendering legal advice to the 
organizational client. * * * and therefore have the professional 
obligations of an attorney.''\51\ The substitution of the term 
``providing legal services'' responds to these concerns. We believe 
that this change, combined with the narrowing of the definition of the 
term ``appearing and practicing'' as set forth above, addresses the 
concerns expressed by the ABA and others.\52\
---------------------------------------------------------------------------

    \51\ Comments of the American Bar Association, at 14 (``It is 
not uncommon for persons who were attorneys and may still retain 
their license to move into other non-legal capacities in the 
organization. * * * These persons should be subject to no greater 
obligations to the organization than someone who is not an 
attorney.''). However, the ABA stated that it believed that the rule 
``appropriately applied to any attorney for the issuer'' who renders 
legal advice to the issuer. Id.
    \52\ We also note that the change should address concerns 
expressed that counsel to underwriters or similar persons might be 
covered by the rule.
---------------------------------------------------------------------------

    For the reasons explained in the proposing release,\53\ an attorney 
employed by an investment adviser who prepares, or assists in 
preparing, materials for a registered investment company 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 is 
appearing and practicing before the Commission under this definition.
---------------------------------------------------------------------------

    \53\ 67 FR 71678-79.
---------------------------------------------------------------------------

    Although some commenters objected to this construction of the 
definition of ``in the representation of an issuer,''\54\ those 
commenters did not contest either the fact that such an attorney, 
though employed by the investment adviser rather than the investment 
company, is providing legal services for the investment company or the 
logical implication of that fact: that the attorney employed by the 
investment adviser is accordingly representing the investment company 
before the Commission.\55\ Indeed, the Investment Company Institute 
(``ICI'') opposes the Commission's construction of its rule because, 
the ICI asserts, the Commission's construction might make investment 
advisers limit the participation of attorneys employed or retained by 
the investment adviser in preparing filings for investment companies, 
thereby forcing the investment companies ``to retain their own 
counsel'' to do exactly the same work now performed by attorneys for 
the investment adviser.\56\
---------------------------------------------------------------------------

    \54\ See, e.g., Comments of the Investment Company Institute at 
1-5 (asserting that the Commission's construction of its rule may 
cause investment advisers to ``limit or even eliminate the 
participation of their internal and outside lawyers in the 
preparation of fund filings and materials, and in providing day-to-
day advice to advisory personnel responsible for managing funds, in 
order to ensure that such lawyers are not `involved in the 
representation of an issuer' or `practicing before the Commission' 
within the meaning of the proposed rule.'').
    \55\ On the correctness of this inference, see, e.g., Comments 
of Thomas D. Morgan at 3-4 (pointing out that ``current law'' makes 
an attorney employed by an investment adviser the ``legal 
representative'' of an investment company under these circumstances, 
although one has to take ``a logical step'' to reach that 
conclusion) (citing Restatement (Third) of the Law Governing Lawyers 
section 51(4)(2000)). An attorney-client relationship does not 
depend on payment for legal services performed. However, the legal 
services provided by an investment adviser to an investment company 
are usually performed pursuant to an advisory contract along with 
other services (such as investment advice) and are covered by the 
overall investment advisory fee.
    \56\ Comments of the Investment Company Institute, at 4. As 
noted in the proposing release, 67 FR 71678-79, and below in the 
discussion of Section 205.3(b), an attorney employed by an 
investment adviser who becomes aware of evidence of a material 
violation that is material to an investment company while thus 
representing that investment company before the Commission has a 
duty to report such evidence up-the-ladder within the investment 
company. For the reasons explained in the proposing release and 
noted below, however, such reporting does no violence to the 
attorney-client privilege. See Restatement (Third) of the Law 
Governing Lawyers, section 75 and cmt. d (explaining that in a 
subsequent proceeding in which the co-client's interests are adverse 
there is normally no attorney-client privilege regarding either co-
client's communications with their attorney during the co-client 
relationship).

---------------------------------------------------------------------------

[[Page 6303]]

---------------------------------------------------------------------------
    205.2(h) provides:

    (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.

    The definition for the term ``issuer'' we adopt today incorporates 
the definition set forth in Section 2(a)(7) of the Act, which in turn 
incorporates the definition contained in the Exchange Act. The 
definition has been modified to specifically exclude foreign government 
issuers, defined above.\57\
---------------------------------------------------------------------------

    \57\ We also note that the changes should address concerns 
expressed that counsel to underwriters or similar persons might be 
covered by the rule.
---------------------------------------------------------------------------

    The definition also has been modified to make clear that, for 
purposes of the terms ``appearing and practicing'' before the 
Commission and ``in the representation of an issuer,'' the term 
``issuer'' includes any person controlled by an issuer (e.g., a wholly-
owned subsidiary), where the attorney provides legal services to that 
person for the benefit of or on behalf of an issuer. We consider the 
change important to achieving the objectives of Section 307 in light of 
the statutory reference to appearing and practicing ``in any way'' in 
the representation of an issuer. Under the revised definition, an 
attorney employed or retained by a non-public subsidiary of a public 
parent issuer will be viewed as ``appearing and practicing'' before the 
Commission ``in the representation of an issuer'' whenever acting ``on 
behalf of, or at the behest, or for the benefit of'' the parent. This 
language, consistent with the Commission's comment in the proposing 
release (although now limited to persons controlled by an issuer) would 
encompass any subsidiary covered by an umbrella representation 
agreement or understanding, whether explicit or implicit, under which 
the attorney represents the parent company and its subsidiaries, and 
can invoke privilege claims with respect to all communications 
involving the parent and its subsidiaries. Similarly, an attorney at a 
non-public subsidiary appears and practices before the Commission in 
the representation of an issuer when he or she is assigned work by the 
parent (e.g., preparation of a portion of a disclosure document) which 
will be consolidated into material submitted to the Commission by the 
parent, or if he or she is performing work at the direction of the 
parent and discovers evidence of misconduct which is material to the 
parent. The definition of the term is also intended to reflect the duty 
of an attorney retained by an issuer to report to the issuer evidence 
of misconduct by an agent of the issuer (e.g., an underwriter) if the 
misconduct would have a material impact upon the issuer.\58\
---------------------------------------------------------------------------

    \58\ An attorney who represents a subsidiary or other person 
controlled by an issuer at the behest, for the benefit, or on behalf 
of a parent issuer who becomes aware of evidence of a material 
violation that is material to the issuer should report the evidence 
up-the-ladder through the issuer, as set forth in Section 205.3(b) 
of the rule.
---------------------------------------------------------------------------

    205.2(i) provides:

    (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.

    The definition we adopt today modifies the definition set forth in 
the proposed rule by adding the phrases ``United States federal or 
state'' and ``arising under United States federal or state law.'' This 
modification clarifies that material violations must arise under United 
States law (federal or state), and do not include violations of foreign 
laws. The final rule does not define the word ``material,'' because 
that term has a well-established meaning under the federal securities 
laws \59\ and the Commission intends for that same meaning to apply 
here.
---------------------------------------------------------------------------

    \59\ See Basic, Inc. v. Levinson, 485 U.S. 224, 231-36 (1988); 
TSC Indus. v. Northway, Inc, 426 U.S. 438 (1976).
---------------------------------------------------------------------------

    205.2(j) provides:

    (j) Non-appearing foreign attorney means an attorney:
    (1) Who is admitted to practice law in a jurisdiction outside 
the United States;
    (2) Who does not hold himself or herself out as practicing, and 
does not give legal advice regarding, United States federal or state 
securities or other laws (except as provided in paragraph (j)(3)(ii) 
of this section); and
    (3) Who:
    (i) Conducts activities that would constitute appearing and 
practicing before the Commission only incidentally to, and in the 
ordinary course of, the practice of law in a jurisdiction outside 
the United States; or
    (ii) Is appearing and practicing before the Commission only in 
consultation with counsel, other than a non-appearing foreign 
attorney, admitted or licensed to practice in a state or other 
United States jurisdiction.

    The final rule provides that a ``non-appearing foreign attorney'' 
does not ``appear and practice before the Commission'' for purposes of 
the rule. In brief, the definition excludes from the rule those 
attorneys who: (1) Are admitted to practice law in a jurisdiction 
outside the United States; (2) do not hold themselves out as 
practicing, or giving legal advice regarding, United States law; and 
(3) conduct activities that would constitute appearing and practicing 
before the Commission only (i) incidentally to a foreign law practice, 
or (ii) in consultation with United States counsel. A non-United States 
attorney must satisfy all three criteria of the definition to be 
excluded from the rule.
    The effect of this definition will be to exclude many, but not all, 
foreign attorneys from the rule's coverage. Foreign attorneys who 
provide legal advice regarding United States securities law, other than 
in consultation with United States counsel, are subject to the rule if 
they conduct activities that constitute appearing and practicing before 
the Commission. For example, an attorney licensed in Canada who 
independently advises an issuer regarding the application of Commission 
regulations to a periodic filing with the Commission is subject to the 
rule. Non-United States attorneys who do not hold themselves out as 
practicing United States law, but who engage in activities that 
constitute appearing and practicing before the Commission, are subject 
to the rule unless they appear and practice before the Commission only 
incidentally to a foreign law practice or in consultation with United 
States counsel.
    Proposed Part 205 drew no distinction between the obligations of 
United States and foreign attorneys. The proposing release requested 
comment on the effects of the proposed rule on attorneys who are 
licensed in foreign jurisdictions or otherwise subject to foreign 
statutes, rules and ethical standards. The Commission recognized that 
the proposed rule could raise difficult issues for foreign lawyers and

[[Page 6304]]

international law firms because applicable foreign standards might be 
incompatible with the proposed rule. The Commission also recognized 
that non-United States lawyers play significant roles in connection 
with Commission filings by both foreign and United States issuers.
    On December 17, 2002, the Commission hosted a Roundtable on the 
International Impact of the Proposed Rules Regarding Attorney Conduct. 
The Roundtable offered foreign participants the opportunity to share 
their views on the application of the proposed rule outside of the 
United States. The participants consisted of international regulators, 
professional associations, and law firms, among others. Participants at 
the Roundtable expressed concern about many aspects of the proposed 
rule. Some objected to the scope of the proposed definition of 
``appearing and practicing before the Commission,'' noting that a 
foreign attorney who prepares a contract or other document that 
subsequently is filed as an exhibit to a Commission filing might be 
covered by the rule. In addition, some of the participants stated that 
foreign attorneys with little or no experience or training in United 
States securities law may not be competent to determine whether a 
material violation has occurred that would trigger reporting 
requirements. Others stated that the ``noisy withdrawal'' and 
disaffirmation requirements of the proposed rule would conflict with 
the laws and principles of confidentiality and the attorney-client 
privilege recognized in certain foreign jurisdictions.
    The Commission received more than 40 comment letters that addressed 
the international aspects of the proposed attorney conduct rule. Many 
suggested that non-United States attorneys should be exempt from the 
rule entirely, arguing that the Commission would violate principles of 
international comity by exercising jurisdiction over the legal 
profession outside of the United States. Others recommended that the 
Commission take additional time to consider these conflict issues, and 
provide a temporary exemption from the rule for non-United States 
attorneys. The majority of commenters asserted that the proposed rule's 
``noisy withdrawal'' and disaffirmation requirements would conflict 
with their obligations under the laws of their home jurisdictions.
    Section 205.2(j) and the final definition of ``appearing and 
practicing before the Commission'' under Sec.  205.2(a) together 
address many of the concerns expressed by foreign lawyers. Foreign 
lawyers who are concerned that they may not have the expertise to 
identify material violations of United States law may avoid being 
subject to the rule by declining to advise their clients on United 
States law or by seeking the assistance of United States counsel when 
undertaking any activity that could constitute appearing and practicing 
before the Commission. Mere preparation of a document that may be 
included as an exhibit to a filing with the Commission does not 
constitute ``appearing and practicing before the Commission'' under the 
final rule, unless the attorney has notice that the document will be 
filed with or submitted to the Commission and he or she provides advice 
on United States securities law in preparing the document.
    The Commission respects the views of the many commenters who 
expressed concerns about the extraterritorial effects of a rule 
regulating the conduct of attorneys licensed in foreign jurisdictions. 
The Commission considers it appropriate, however, to prescribe 
standards of conduct for an attorney who, although licensed to practice 
law in a foreign jurisdiction, appears and practices on behalf of his 
clients before the Commission in a manner that goes beyond the 
activities permitted to a non-appearing foreign attorney. Non-United 
States attorneys who believe that the requirements of the rule conflict 
with law or professional standards in their home jurisdiction may avoid 
being subject to the rule by consulting with United States counsel 
whenever they engage in any activity that constitutes appearing and 
practicing before the Commission. In addition, as discussed in Section 
205.6(d) below, the Commission is also adopting a provision to protect 
a lawyer practicing outside the United States in circumstances where 
foreign law prohibits compliance with the Commission's rule.
    205.2(k) provides:

    (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 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 Sec.  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 Sec.  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
    (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.

    A QLCC, as here defined, is part of an alternative procedure for 
reporting evidence of a material violation. That alternative procedure 
is set out in Sec.  205.3(c) of the rule.
    The definition of a QLCC in Sec.  205.2(k) of the final rule 
contains a few modifications from the definition in the proposed rule. 
In the first clause of the definition, the final rule provides that an 
audit or other committee of the issuer may serve as the QLCC. As a 
result, the issuer is not required to form a QLCC as a new corporate 
structure, unless it wishes to, so long as another committee of the 
issuer meets all of the requisite criteria for a QLCC and agrees to 
function as a QLCC in addition to its separate duties and 
responsibilities. This change responds to comments that issuers should 
not be required to create a new committee to serve as a QLCC, so long 
as an existing committee contains the required number of independent 
directors.\60\
---------------------------------------------------------------------------

    \60\ Comments of the American Corporate Counsel Association, at 
9-10; Comments of Association of the Bar of the City of New York, at 
42; Comments of Corporations Committee, Business Law Section, State 
Bar of California, at 12; Comments of Skadden, Arps, Slate, Meagher 
& Flom, at 12, 20, 25.

---------------------------------------------------------------------------

[[Page 6305]]

    Subsection 205.2(k)(1) of the final rule, which addresses the 
composition of the QLCC, provides that if an issuer has no audit 
committee, the requirement to appoint at least one member of the audit 
committee to the QLCC may be met by appointing instead a member from an 
equivalent committee of independent directors. The Commission does not 
intend to limit use of the QLCC mechanism only to those issuers that 
have an audit committee. However, the Commission believes that the 
requirement that the QLCC be comprised of members who are not employed 
directly or indirectly by the issuer is warranted and appropriate, and 
thus disagrees with a commenter's suggestion to permit non-independent 
board members to be on the QLCC.\61\
---------------------------------------------------------------------------

    \61\ See Comments of America's Community Bankers, at 5-6.
---------------------------------------------------------------------------

    Subsection 205.2(k)(3)(iii)(A) has been modified to clarify that 
the QLCC shall have the authority and responsibility to recommend that 
an issuer implement an appropriate response to evidence of a material 
violation, but not to require the committee to direct the issuer to 
take action. This modification responds to comments that the proposed 
rule would be in conflict with established corporate governance models 
insofar as the QLCC would have the explicit authority to compel a board 
of directors to take certain remedial actions.\62\
---------------------------------------------------------------------------

    \62\ Comments of Business Law Section, New York State Bar 
Association, at 14-15; Comments of the Business Roundtable, at 2-3.
---------------------------------------------------------------------------

    The proposed rule did not specify whether the QLCC could act if its 
members did not all agree. In response to comments expressing concern 
over this point,\63\ language has been included in subsections 
205.2(k)(3) and (4) of the final rule to clarify that decisions and 
actions of the QLCC must be made and taken based upon majority vote. 
Unanimity is not required for a QLCC to operate; nor should an 
individual member of a QLCC act contrary to the collective decision of 
the QLCC. Accordingly, the final rule specifies that a QLCC may make 
its recommendations and take other actions by majority vote.
---------------------------------------------------------------------------

    \63\ Comments of the American Bar Association, at 27; Comments 
of Business Law Section, New York State Bar Association, at 15.
---------------------------------------------------------------------------

    Commenters suggested both that issuers would have great difficulty 
finding qualified persons to serve on a QLCC because of the burdens and 
risks of such service,\64\ and that many companies will utilize a QLCC 
because reporting evidence of a material violation to a QLCC relieves 
an attorney of responsibility to assess the issuer's response.\65\ The 
Commission does not know how widespread adoption of the QLCC 
alternative will be, but encourages issuers to do so as a means of 
effective corporate governance. In any event, the Commission does not 
intend service on a QLCC to increase the liability of any member of a 
board of directors under state law and, indeed, expressly finds that it 
would be inconsistent with the public interest for a court to so 
conclude.
---------------------------------------------------------------------------

    \64\ Comments of Clifford Chance, at 4-5; Comments of Emerson 
Electric Co., at 5.
    \65\ Comments of Susan P. Koniak et al., at 11; Comments of 
Richard W. Painter, at 5; Comments of Thomas D. Morgan, at 12.
---------------------------------------------------------------------------

    As in the proposed rule, the final rule provides that members of 
the QLCC may not be ``employed, directly or indirectly, by the 
issuer.'' This language, which is also included in Section 205.3(b)(3), 
is drawn directly from Section 307 of the Sarbanes-Oxley Act. The 
Commission considers it appropriate and consistent with the mandate of 
the Act to ensure a high degree of independence in QLCC members and 
members of committees to whom reports are made under Section 
205.3(b)(3). Accordingly, the Commission anticipates that these 
provisions will be amended to conform to final rules defining who is an 
``independent'' director under Section 301 of the Act, upon adoption of 
those rules.
    205.2(l) provides:

    (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.

    The definition of ``reasonable'' or ``reasonably'' is based on Rule 
1.0(h) of the ABA's Model Rules of Professional Conduct, modified to 
emphasize that a range of conduct may be reasonable.
    205.2(m) provides:

    (m) Reasonably believes means that an attorney believes the 
matter in question and that the circumstances are such that the 
belief is not unreasonable.

    This definition is based on the definition of ``reasonable belief'' 
or ``reasonably believes'' in Rule 1.0(i) of the ABA's Model Rules of 
Professional Conduct, modified to emphasize that the range of possible 
reasonable beliefs regarding a matter may be broad--limited for the 
purposes of this rule by beliefs that are unreasonable. Because the 
definition no longer is used in connection with the definition of 
``evidence of a material violation,'' the proposed rule's attempt to 
exclude the subjective element in ``reasonable belief'' has been 
abandoned.
    205.2(n) provides:

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

    The definition for this term has not been changed from the one 
included in the proposed rule.

Section 205.3--Issuer as Client

    205.3(a) provides:

    (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.

    This section makes explicit that the client of an attorney 
representing an issuer before the Commission is the issuer as an entity 
and not the issuer's individual officers or employees that the attorney 
regularly interacts with and advises on the issuer's behalf. Most 
commenters supported the second sentence of the subsection as it is 
consistent with a lawyer's recognized obligations under accepted 
notions of professional responsibility.\66\ Thus, this sentence remains 
unchanged in the final rule.
---------------------------------------------------------------------------

    \66\ See ABA Model Rule 1.13, ``Organization as Client,'' at 
1:139.
---------------------------------------------------------------------------

    The proposed rule provided that an attorney ``shall act in the best 
interest of the issuer and its shareholders.'' Commenters raised three 
principal concerns regarding that provision: It misstates an attorney's 
duty under traditional ethical standards in charging an attorney with 
acting in the ``best interest'' of the issuer; it suggests attorneys 
have a duty to shareholders creating a risk that the failure to observe 
that duty could form the basis for a private action against the 
attorney by any of these shareholders;\67\ and it appears to contradict 
the view expressed by the Commission in the proposing release that 
``nothing in Section 307 creates a private right of action against an 
attorney.'' \68\ As the Commission agrees, in part, with these 
comments, it has modified language in the final rule.
---------------------------------------------------------------------------

    \67\ See, e.g., Comments of Cleary, Gottlieb, Steen & Hamilton, 
at 3-4; Comments of Corporations Committee, Business Law Section, 
The State Bar of California, at 7; Comments of the American 
Corporate Counsel Association, at 11; Comments of Task Force on 
Corporate Responsibility of the County of New York Lawyers' 
Association, at 2-3.
    \68\ See Comments of the Association of the Bar of the City of 
New York, at 47-50.
---------------------------------------------------------------------------

    As to the first concern, the Commission recognizes that it is the 
client issuer, acting through its management, who chooses the

[[Page 6306]]

objectives the lawyer must pursue, even when unwise, so long as they 
are not illegal or unethical. However, we disagree with the comment to 
the extent it suggests counsel is never charged with acting in the best 
interests of the issuer. ABA Model Rule 1.13 provides that an attorney 
is obligated to act in the ``best interests'' of an issuer in 
circumstances contemplated by this rule: that is, when an individual 
associated with the organization is violating a legal duty, and the 
behavior ``is likely to result in substantial injury'' to the 
organization. In those situations, it is indeed appropriate for counsel 
to act in the best interests of the issuer by reporting up-the-
ladder.\69\ However, the Commission appreciates that, with respect to 
corporate decisions traditionally reserved for management, counsel is 
not obligated to act in the ``best interests'' of the issuer. Thus, the 
reference in the proposed rule to the attorney having a duty to act in 
the best interests of the issuer has been deleted from the final rule. 
The sentence has also been modified to make it clear the lawyer ``owes 
his or her professional and ethical duties to the issuer as an 
organization.''
---------------------------------------------------------------------------

    \69\ See ABA Model Rule 1.13, at 1:139.
---------------------------------------------------------------------------

    As to the second concern, the courts have recognized that counsel 
to an issuer does not generally owe a legal obligation to the 
constituents of an issuer--including shareholders.\70\ The Commission 
does not want the final rule to suggest it is creating a fiduciary duty 
to shareholders that does not currently exist. Accordingly, we have 
deleted from the final rule the reference to the attorney being 
obligated to act in the best interest of shareholders. This 
modification should also address the third concern as the Commission 
does not intend to create a private right of action against attorneys 
or any other person under any provision of this part. Indeed, the final 
rule contains a new provision, 205.7, that expressly provides that 
nothing in this part is intended to or does create a private right of 
action.
---------------------------------------------------------------------------

    \70\ Decisions in a number of states recognize that, under state 
law, an attorney for an issuer does not owe a fiduciary duty to 
shareholders. See Pelletier v. Zweifel, 921 F.2d 1465, 1491-92 n.60 
(11th Cir.) cert. denied, 502 U.S. 955 (1991) (Under Georgia law 
``[I]t is a black letter principle of corporation law that a 
corporation's counsel does not owe * * * [a] fiduciary duty to the 
corporation's shareholders''). See also Skarbrevik v. Cohen, England 
& Whitfield, 231 Cal. App. 3d 692, 703 (1991) (Under California law, 
``[a]n attorney representing a corporation does not become the 
representative of its stockholders merely because the attorney's 
actions on behalf of the corporation also benefit the stockholders; 
as attorney for the corporation, counsel's first duty is to the 
corporation.''); Egan v. McNamara, 467 A.2d 733, 738 (DC 1983) 
(``According to the District of Columbia Code of Professional 
Responsibility (Code), an attorney represents, and therefore owes a 
duty to, the entity that retains him. * * * When retained to 
represent a corporation, he represents the entity, not its 
individual shareholders, officers, or directors.'').
---------------------------------------------------------------------------

    205.3(b) provides:

    (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.

    Section 205.3(b) clarifies an attorney's duty to protect the 
interests of the issuer the attorney represents by reporting within the 
issuer evidence of a material violation by any officer, director, 
employee, or agent of the issuer. The section was broadly approved by 
commenters. Paragraph (b)(1) describes the first step that an attorney 
representing an issuer is required to take after he or she becomes 
aware of evidence of a material violation, now defined in Sec.  205.2. 
The definition of ``evidence of a material violation'' originally 
proposed was controversial and has been modified (as discussed above). 
Paragraph (b)(1), however, was otherwise generally approved.\71\
---------------------------------------------------------------------------

    \71\ The Comment of Federal Bar Counsel, at 12-13, for example, 
objected to ``becomes aware'' in (b)(1) but appears to have done so 
in connection with the proposed definition of ``evidence of a 
material violation.'' The revisions made to that definition appear 
to address those objections.
---------------------------------------------------------------------------

Section 205.3(b)(2) in Proposed Rule: Withdrawn

    (2) The attorney reporting evidence of a material violation 
shall take steps reasonable under the circumstances to document the 
report and the response thereto and shall retain such documentation 
for a reasonable time.

    The language set forth from proposed subsection 205.3(b)(2) of the 
proposed rule has been withdrawn.
    In the final rules we have eliminated all requirements that reports 
and responses be documented and maintained for a reasonable period. 
Under the proposed rule, a lawyer would have been required to document 
his or her report of evidence of a material violation (205.3(b)(2)); 
the CLO would have been required to document any inquiry in response to 
a report (205.3(b)(3)); a reporting attorney would have been required 
to document when he or she received an appropriate response to a report 
(205.3(b)(2)); and an attorney who believed he or she did not receive 
an appropriate response to a report would have been required to 
document that response (205.3(b)(8)(ii)).
    The Commission proposed the documentation requirements because it 
believed that up-the-ladder reporting would be handled more 
thoughtfully if those involved memorialized their decisions. It was 
also the Commission's view that documentation would benefit reporting 
attorneys as it would provide them with a contemporaneous written 
record of their actions that they could use in their defense if their 
up-the-ladder reporting subsequently became the subject of litigation. 
To that end, the Commission proposed 205.3(e)(1) (which is codified in 
the final rule as Sec.  205.3(d)(1)) that specifically authorizes an 
attorney to use ``[a]ny report under this section * * * or any response 
thereto * * * in connection with any investigation, proceeding, or 
litigation in which the attorney's compliance with this part is in 
issue.'' Moreover, the Commission noted (see note 52 to the proposing 
release) that in at least one reported judicial decision, an associate 
at a law firm who had memorialized his reasons for resigning from the 
firm over a dispute regarding the adequacy of disclosures in a 
registration statement, was dismissed as a defendant in subsequent 
litigation over the appropriateness of those disclosures because his 
contemporaneous record demonstrated he had not participated in the 
fraud.
    Nevertheless, the comments that the Commission received to the 
proposed documentation requirements were almost unanimously in 
opposition to its inclusion in the final rule. A number of commenters 
expressed concern that the documentation requirement could be an 
impediment to open and candid discussions between attorneys and their 
issuer clients. Those commenters were of the view it would stultify the 
consultation process because if the client knows the lawyer is 
documenting discussions regarding a potential material violation, 
managers are less likely to be honest and forthcoming.\72\
---------------------------------------------------------------------------

    \72\ See, e.g., Comments of the American Bar Association, at 22; 
Comments of the American Corporate Counsel Association, at 5; 
Comments of the Association of the Bar of the City of New York, at 
16; Comments of Cleary, Gottlieb, Steen & Hamilton, at 6.
---------------------------------------------------------------------------

    Other commenters expressed concern that the documentation 
requirement has the potential to create a conflict of interest between 
the lawyer and his or her client. For example, one commenter

[[Page 6307]]

stated that it ``places counsel to the issuer in the untenable position 
of having to protect himself or herself while trying to advise his or 
her client.'' \73\ Similarly, another commenter pointed out that 
documentation would ``occur at exactly the time when there was 
disagreement between an attorney and the client. At the very least, 
requiring the attorney to produce such product by virtue of his or her 
separate obligation to the Commission is bound to present potential for 
conflict of interest.'' \74\ Indeed, it was pointed out, there may be 
occasions where the preparation of documentation is not in the best 
interests of the client.\75\
---------------------------------------------------------------------------

    \73\ Comments of Skadden, Arps, Slater, Meagher & Flom, at 23.
    \74\ Comments of Corporations Committee, Business Law Section, 
the State Bar of California, at 10.
    \75\ Id.
---------------------------------------------------------------------------

    Additionally, commenters opined that the documentation requirement 
might increase the issuer's vulnerability in litigation. They noted 
that a report will be a ``treasure trove of selectively damning 
evidence'' \76\ and, while the Commission may be of the view that such 
documentation should be protected by the attorney-client privilege, the 
applicability of the privilege will be decided by the courts. Thus, 
there is considerable uncertainty as to whether it will be protected. 
At a minimum, it was contended, assertions of privilege will be met 
with significant and prolonged legal challenges.\77\
---------------------------------------------------------------------------

    \76\ Comments of the American Corporate Counsel Association, at 
5.
    \77\ See Comments of Corporations Committee, Business Law 
Section, the State Bar of California, at 10.
---------------------------------------------------------------------------

    At least at the present time, the potential harms from mandating 
documentation may not justify the potential benefits. In all 
likelihood, in the absence of an affirmative documentation requirement, 
prudent counsel will consider whether to advise a client in writing 
that it may be violating the law.\78\ In other situations, responsible 
corporate officials may direct that such matters be documented. In 
those situations, the Commission's goal will be met, but not in an 
atmosphere where the issuer and the attorney may perceive that their 
interests are in conflict.
---------------------------------------------------------------------------

    \78\ See Comments of Cleary, Gottlieb, Steen & Hamilton, at 6.
---------------------------------------------------------------------------

    205.3(b)(2) provides:

    (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.

    Paragraph (b)(2) (corresponding to paragraph (b)(3) of the proposed 
rule, as revised) describes the responsibilities of the issuer's CLO 
(or the equivalent thereof) in handling reported evidence of a material 
violation. The final rule adds a provision expressly allowing the CLO 
to make use of an issuer's QLCC. The revision eliminates the CLO's 
documentation requirement and, for the time being, the CLO's 
obligation, as part of the QLCC process, to notify the Commission in 
the unlikely event that the issuer fails to take appropriate remedial 
actions recommended by the QLCC after a determination by the QLCC that 
there has been or is about to be a material violation. It also changes 
language that would have required a CLO who reasonably believed that a 
material violation had occurred, was ongoing, or was about to occur to 
``take any necessary steps to ensure that the issuer adopts an 
appropriate response'' to language that would, under the same 
circumstances, require the CLO to ``take all reasonable steps to cause 
the issuer to adopt an appropriate response.'' These are the points on 
which the corresponding paragraph in the proposed rule was 
criticized.\79\ Reporting up-the-ladder was otherwise consistently 
supported. The CLO is responsible for investigating the reported 
evidence of a material violation for the reasons set out in the 
proposing release.\80\ The second sentence of this paragraph has been 
modified to clarify the circumstances under which the CLO must advise a 
reporting attorney that no violation has been found. Thus, the term 
``determines'' has been substituted for ``reasonably believes'' in the 
second sentence. This change makes the second sentence consistent with 
the first sentence which requires the CLO to cause an inquiry to be 
conducted ``to determine'' whether a violation has occurred, is 
ongoing, or is about to occur. Other minor textual changes have been 
made to the paragraph that do not alter its substantive requirements.
---------------------------------------------------------------------------

    \79\ E.g., Comments of the SIA/TBMA, at 16 (CLO should be able 
to make use of the QLCC); Comments of J.P. Morgan Chase & Co., at 3 
(CLO should not be required to notify the Commission that a material 
violation has occurred and disaffirm documents that the issuer has 
submitted to or filed with the Commission that the CLO believes are 
false or materially misleading); Comments of Compass Bancshares, at 
2-3 (requiring CLO ``to issue a response in writing to the attorney 
creates an undue burden on the CLO [in] responding to an issue which 
the CLO may not feel is warranted''); Comments of Charles Schwab & 
Co., at 1-2 (CLO ``typically does not have authority to sanction 
employees outside of his or her chain of command, to require the 
business units to adopt new procedures, or even to make disclosure 
on behalf of the company without the concurrence of other 
executives'').
    \80\ 67 FR 71685-86.
---------------------------------------------------------------------------

    205.3(b)(3) provides:

    (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 
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))).

    This paragraph describes the circumstances under which an attorney 
who has reported evidence of a material violation to the issuer's CLO 
and/or CEO is obliged to report that evidence further up-the-ladder 
within the client issuer. The paragraph tracks the statutory language 
in Section 307 of the Act, is not controversial, and is adopted without 
change from the corresponding paragraph in the proposed rule--(b)(4)--
for the reasons set out in the proposing release.\81\
---------------------------------------------------------------------------

    \81\ 67 FR 71686.
---------------------------------------------------------------------------

    205.3(b)(4) provides:

    (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

[[Page 6308]]

evidence as provided under paragraph (b)(3) of this section.

    The basis for paragraph (b)(4) is implicit in Section 307 of the 
Act. This bypass provision, however, is not controversial, was not the 
subject of comment, and is adopted without any substantive change from 
the corresponding paragraph--(b)(5)--of the proposed rule for the 
reasons set out in the proposing release.\82\
---------------------------------------------------------------------------

    \82\ 67 FR 71686.
---------------------------------------------------------------------------

    205.3(b)(5) provides:

    (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.

    Paragraph (b)(5) addresses circumstances in which those to whom 
evidence of a material violation is reported direct others, either in-
house attorneys or outside attorneys retained for that purpose, to 
investigate the possible violation. It elicited only a few comments, 
all of them negative.\83\ The thrust of these comments was that issuers 
would be reluctant to retain counsel to investigate reports if those 
attorneys might trigger up-the-ladder reporting that could result in 
reporting out to the Commission. The definition of ``appropriate 
response'' in section 205.2(b) of the final rule has been modified to 
address these comments. Further, the modifications to the proposed rule 
reflected in final rule Sec. Sec.  205.3(b)(6) and (b)(7) below, will 
relieve attorneys retained or directed to investigate or litigate 
reports of violations from reporting up-the-ladder in a number of 
instances.
---------------------------------------------------------------------------

    \83\ See Comments of Schiff Hardin & Waite, at 4 (paragraph 
(b)(5) as proposed goes ``too far'' in deeming a lawyer engaged by 
an issuer to conduct an internal investigation of a possible 
material violation of the securities laws to be appearing and 
practicing before the Commission and that issuers will be reluctant 
to retain independent counsel to investigate if the independent 
counsel have ``an obligation to effect a noisy withdrawal if they 
disagree with the client's response to the finding or recommendation 
resulting from the investigation''); Comments of the Chicago Bar 
Association, at 3 (paragraph as proposed is overbroad in requiring 
an outside lawyer engaged to investigate whether a violation has 
occurred to withdraw and notify the Commission if it disagrees with 
the issuer); Comments of the Corporation, Finance and Securities Law 
Section of the District of Columbia Bar, at 4-5 (``attorneys 
conducting an internal investigation, and not otherwise interacting 
with the Commission or even known to the Commission at that point, 
do not have a sufficient nexus with the Commission's processes'' to 
be covered by the Commission's rules; making them subject to the 
Commission's rules will ``make issuers less willing to retain, and 
attorneys less willing to conduct, such investigations''; and is 
unnecessary because section 205.3(b)(2) requires an issuer's CLO 
``to assess the timeliness and appropriateness of the issuer's 
response'').
---------------------------------------------------------------------------

    Paragraph (b)(5) is adopted essentially as proposed. This 
paragraph--numbered (b)(6) in the proposed rule `` makes two points: 
first, that the investigating attorneys are themselves appearing and 
practicing before the Commission and are accordingly bound by the 
requirements of the proposed rule; and, second, that the officers or 
directors who caused them to investigate remain obligated to respond to 
the attorney who initially reported the evidence of a material 
violation that other attorneys have been directed to investigate.
    205.3(b)(6) and (b)(7) provide:

    (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 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 such evidence of a material 
violation, and the chief legal officer (or the equivalent thereof) 
provides reasonable and timely reports on the progress and outcome 
of such proceeding 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.
    (7) An attorney shall not have any obligation to report evidence 
of a material violation under this paragraph (b) if such attorney 
was retained or directed by a qualified legal compliance committee:
    (i) To investigate such evidence of a material violation; or
    (ii) To assert, consistent with his or her professional 
obligations, 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 such evidence of a material violation.

    As noted above in our discussion of paragraph (b)(5) of the final 
rule, a number of commenters expressed the view that the final rule 
should eliminate any requirement that attorneys report up-the-ladder 
when they are retained or directed to investigate a report of a 
material violation or to litigate whether a violation has occurred. New 
paragraphs (b)(6) and (b)(7) respond to these legitimate comments, and 
narrow considerably the instances when it is likely to be necessary for 
such an attorney to report up-the-ladder. Paragraph (b)(6) addresses 
the responsibilities of attorneys retained or directed to investigate 
or litigate reported violations by the chief legal officer (or the 
equivalent thereof); paragraph (b)(7) addresses circumstances where 
attorneys are retained or directed to investigate or litigate reported 
violations by a qualified legal compliance committee. Where an attorney 
is retained to investigate by the chief legal officer, the attorney has 
no obligation to report where the results of the investigation are 
provided to the chief legal officer and the attorney and the chief 
legal officer agree no violation has occurred and report the results of 
the inquiry to the issuer's board of directors or to an independent 
committee of the board. An attorney retained or directed by the chief 
legal officer to litigate a reported violation does not have a 
reporting obligation so long as he or she is able to assert a colorable 
defense on behalf of the issuer and the chief legal officer provides 
reports on the progress and outcome of the litigation to the issuer's 
board of directors. An attorney retained or directed by a qualified 
legal compliance committee to investigate a reported violation has no 
reporting obligations. Similarly, an attorney retained or directed by a 
qualified legal compliance committee to litigate a reported violation 
has no reporting obligation provided he or she may assert a colorable 
defense on behalf of the issuer.
    205.3(b)(8) and (b)(9) provide:

    (8) An attorney who receives what he or she reasonably believes 
is an appropriate and timely response to a report he or she has made 
pursuant to paragraph (b)(1), (b)(3), or (b)(4) of this section need 
do nothing more under this section with respect to his or her 
report.
    (9) An attorney who does not reasonably believe that the issuer 
has made an appropriate response within a reasonable time to the 
report or reports made pursuant to paragraph (b)(1), (b)(3), or 
(b)(4) of this section shall explain his or her reasons therefor to 
the chief legal officer (or the equivalent thereof), the chief 
executive officer (or the equivalent thereof), and directors to whom 
the attorney reported the evidence of a material violation pursuant 
to

[[Page 6309]]

paragraph (b)(1), (b)(3), or (b)(4) of this section.

    As proposed, paragraphs (b)(8) and (b)(9)--numbered (b)(7) and 
(b)(8) in the proposed rule--elicited no comment (apart from negative 
comments on documentation provisions that have been eliminated in the 
final rule). They are adopted without any other substantive change for 
reasons explained in the proposing release.\84\
---------------------------------------------------------------------------

    \84\ 67 FR 71687.
---------------------------------------------------------------------------

    205.3(b)(10) provides:

    (10) An attorney formerly employed or retained by an issuer who 
has reported evidence of a material violation under this part and 
reasonably believes that he or she has been discharged for so doing 
may notify the issuer's board of directors or any committee thereof 
that he or she believes that he or she has been discharged for 
reporting evidence of a material violation under this section.

    Paragraph (b)(10) authorizes an attorney to notify an issuer's 
board of directors or any committee thereof if the attorney reasonably 
believes that he or she has been discharged for reporting evidence of a 
material violation under this section. This provision, an important 
corollary to the up-the-ladder reporting requirement, is designed to 
ensure that a chief legal officer (or the equivalent thereof) is not 
permitted to block a report to the issuer's board or other committee by 
discharging a reporting attorney.
    This provision is similar in concept to paragraph (d)(4) of the 
proposed rule (as to which, as noted above, the Commission is seeking 
further comment), although it does not provide for reporting outside 
the issuer.
    205.3(c) provides:

    (c) Alternative reporting procedures for attorneys retained or 
employed by an issuer that has established a qualified legal 
compliance committee. (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 
may, as an alternative to the reporting requirements of paragraph 
(b) of this section, report such evidence to a qualified legal 
compliance committee, if the issuer has previously formed such a 
committee. An attorney who reports evidence of a material violation 
to such a qualified legal compliance committee has satisfied his or 
her obligation to report such evidence and is not required to assess 
the issuer's response to the reported evidence of a material 
violation.
    (2) A chief legal officer (or the equivalent thereof) may refer 
a report of evidence of a material violation to a previously 
established qualified legal compliance committee in lieu of causing 
an inquiry to be conducted under paragraph (b)(2) of this section. 
The chief legal officer (or the equivalent thereof) shall inform the 
reporting attorney that the report has been referred to a qualified 
legal compliance committee. Thereafter, pursuant to the requirements 
under Sec.  205.2(k), the qualified legal compliance committee shall 
be responsible for responding to the evidence of a material 
violation reported to it under this paragraph (c).

    This alternative to the reporting requirements of Sec.  205.3(b) 
would allow, though not require, an attorney to report evidence of a 
material violation directly to a committee of the board of directors 
that meets the definitional requirements for a QLCC. It would also 
relieve the reporting attorney of any further obligation once he or she 
had reported such evidence to an issuer's QLCC.
    Under this alternative, the QLCC--itself a committee of the 
issuer's board of directors with special authority and special 
responsibility--would be responsible for carrying out the steps 
required by Section 307 of the Act: notifying the CLO of the report of 
evidence of a material violation (except where such notification would 
have been excused as futile under Sec.  205.3(b)(4)); causing an 
investigation where appropriate; determining what remedial measures are 
appropriate where a material violation has occurred, is ongoing, or is 
about to occur; reporting the results of the investigation to the CLO, 
the CEO, and the full board of directors; and notifying the Commission 
if the issuer fails in any material respect to take any of those 
appropriate remedial measures.
    More generally, the QLCC institutionalizes the process of reviewing 
reported evidence of a possible material violation. That would be a 
welcome development in itself. It may also produce broader synergistic 
benefits, such as heightening awareness of the importance of early 
reporting of possible material violations so that they can be prevented 
or stopped.
    Probably the most important respect in which Sec.  205.3(c) differs 
from Sec.  205.3(b) is, as noted, that Section 205.3(c) relieves an 
attorney who has reported evidence of a material violation to a QLCC 
from any obligation ``to assess the issuer's response to the reported 
evidence of a material violation.'' If the issuer fails, in any 
material respect to take any remedial action that the QLCC has 
recommended, then the QLCC, as well as the CLO and the CEO, all have 
the authority to take appropriate action, including notifying the 
Commission if the issuer fails to implement an appropriate response 
recommended by the QLCC.
    Commenters generally approved of the QLCC in concept, although 
several proposed changes in how it would work. The American Bar 
Association agreed with the need for corporate governance mechanisms to 
ensure legal compliance once a material violation is reported to an 
issuer's board, but suggested that existing corporate governance 
reforms should be given time before new reforms are added.\85\ Another 
commenter suggested that the QLCC should be only one of a number of 
acceptable governance models, with issuers having freedom to craft 
techniques suitable to their own circumstances.\86\ The Commission 
recognizes these concerns, but believes the benefits of the QLCC model, 
as described above, and the absence of any requirement that an issuer 
form or utilize a QLCC, justify inclusion of this alternative in the 
final rule.
---------------------------------------------------------------------------

    \85\ Comments of the American Bar Association, at 27-28.
    \86\ Comments of the American Corporate Counsel Association, at 
9-10.
---------------------------------------------------------------------------

    One commenter suggested that the Commission's final rules should 
make clear that, for a matter to be referred to a QLCC, the issuer must 
have a QLCC in place and is not permitted simply to establish a QLCC to 
respond to a specific incident.\87\ This comment has been addressed in 
Sec.  205.3(c), which authorizes referral only to a QLCC that has been 
previously formed.
---------------------------------------------------------------------------

    \87\ Comments of Richard W. Painter, at 5.
---------------------------------------------------------------------------

    Commenters made a number of other suggestions regarding the QLCC 
provisions in the proposed rule. One commenter proposed that the 
Commission consider making creation of a QLCC mandatory for each 
issuer.\88\ The Commission believes that keeping the QLCC as an 
alternative reporting mechanism is preferable, and that attorneys 
should be permitted to report up-the-ladder through their chief legal 
officers. Another commenter suggested that the QLCC proposal be 
modified to remove the ``noisy withdrawal'' provision.\89\ The 
Commission has concluded that, in the extraordinary circumstance in 
which an appropriate response does not follow a QLCC's recommendation 
in response to evidence of a material violation, the QLCC should have 
the authority to take all appropriate action, including notifying the 
Commission, although it is not required to do so in every case. Another 
suggestion from a commentator was that the Commission offer a ``safe 
harbor'' for a chief legal officer who

[[Page 6310]]

reports to a QLCC.\90\ The Commission has provided a form of ``safe 
harbor'' against any inconsistent standard of a state or other United 
States jurisdiction in Section 205.6(c), and against a private action 
in Section 205.7.
---------------------------------------------------------------------------

    \88\ Comments of Edward C. Brewer III, at 4.
    \89\ Comments of the Association of the Bar of the City of New 
York, at 41-42.
    \90\ Id., at 42-43.
---------------------------------------------------------------------------

Section 205.3(d) Issuer Confidences

    205.3(d)(1) provides:

    (1) Any report under this section (or the contemporaneous record 
thereof) or any response thereto (or the contemporaneous record 
thereof) may be used by an attorney in connection with any 
investigation, proceeding, or litigation in which the attorney's 
compliance with this part is in issue.

    Paragraph (d)(1) makes clear that an attorney may use any records 
the attorney may have made in the course of fulfilling his or her 
reporting obligations under this part to defend himself or herself 
against charges of misconduct. It is effectively equivalent to the 
ABA's present Model Rule 1.6(b)(3) and corresponding ``self-defense'' 
exceptions to client-confidentiality rules in every state. The 
Commission believes that it is important to make clear in the rule that 
attorneys can use any records they may have prepared in complying with 
the rule to protect themselves.
    One comment expressed concern that this provision would empower the 
Commission to use such records against the attorney. That concern 
misreads this paragraph, which expressly refers to the use of these 
records ``by an attorney'' in a proceeding where the attorney's 
compliance with this part is in issue.
    205.3(d)(2) provides:

    (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:
    (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 investors;
    (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.

    This paragraph thus permits, but does not require, an attorney to 
disclose, under specified circumstances, confidential information 
related to his appearing and practicing before the Commission in the 
representation of an issuer. It corresponds to the ABA's Model Rule 1.6 
as proposed by the ABA's Kutak Commission in 1981-1982 and by the ABA's 
Commission of Evaluation of the Rules of Professional Conduct (``Ethics 
2000 Commission'') in 2000,\91\ and as adopted in the vast majority of 
states.\92\ It provides additional protection for investors by 
allowing, though not requiring, an attorney to disclose confidential 
information relating to his appearing and practicing before the 
Commission in the representation of an issuer to the extent the 
attorney reasonably believes necessary (1) to prevent the issuer from 
committing a material violation that the lawyer reasonably believes is 
likely to result in substantial injury to the financial interest or 
property of the issuer or investors; (2) to prevent the issuer from 
perpetrating a fraud upon the Commission; or (3) to rectify the 
consequences of an issuer's material violations that caused or may 
cause substantial injury to the issuer's financial interest or property 
in the furtherance of which the attorney's services were used.
---------------------------------------------------------------------------

    \91\ ABA, Report of the Commission on Evaluation of the Rules of 
Professional Conduct (November 2000), recommended permitting a 
lawyer to disclose confidential ``information relating to the 
representation of a client to the extent the lawyer reasonably 
believes necessary . . . to prevent the client from committing a 
crime or fraud that is reasonably certain to result in substantial 
injury to the financial interests or property of another and in 
furtherance of which the client has used or is using the lawyer's 
services.''
    \92\ Thirty-seven states permit an attorney to reveal 
confidential client information in order to prevent the client from 
committing criminal fraud. See Restatement (Third) of the Law 
Governing Lawyers (2000) section 67, Cmt. f, and Thomas D. Morgan & 
Ronald D. Rotunda, Model Code of Professional Responsibility, Model 
Rules of Professional Conduct, and Other Selected Standards, at 146 
(reproducing the table prepared by the Attorneys' Liability 
Assurance Society (``ALAS'') cited in the Restatement). The ABA's 
Model Rule 1.6, which prohibits disclosure of confidential client 
information even to prevent a criminal fraud, is a minority rule. In 
its Carter and Johnson decision (1981 WL 384414, at n.78), the 
Commission expressly did not address an attorney's obligation to 
disclose a client's intention to commit fraud or an illegal act.
---------------------------------------------------------------------------

    The proposed version of this rule provided that the attorney 
appearing or practicing before the Commission could disclose 
information to the Commission:

    (i) To prevent the issuer from committing an illegal act that 
the attorney reasonably believes is likely to result in substantial 
injury to the financial interest or property of the issuer or 
investors;
    (ii) To prevent the issuer from committing an illegal act that 
the attorney reasonably believes is likely to perpetrate a fraud 
upon the Commission; or
    (iii) To rectify the consequences of the issuer's illegal act in 
the furtherance of which the attorney's services had been used.

    Several comments stated that permitting attorneys to disclose 
illegal acts to the Commission, in the situations delineated by the 
proposed rule, would undermine the relationship of trust and confidence 
between lawyer and client, and may impede the ability of lawyers to 
steer their clients away from unlawful acts.\93\ Other comments 
expressed concern that this provision conflicts with, and would (in 
their eyes impermissibly) preempt, the rules of professional conduct of 
certain jurisdictions (such as the District of Columbia) which bar the 
disclosure of information which an attorney is permitted to disclose 
under this paragraph, particularly where it permits the disclosure of 
past client misconduct.\94\ Some aver that ``it is not a lawyer's job'' 
in representing an issuer before the Commission ``to correct or rectify 
the consequences of [the issuer's] illegal actions, or even to prevent 
wrong-doing.'' \95\
---------------------------------------------------------------------------

    \93\ See comments of Joseph T. McLaughlin, Heller Ehrman, at 2; 
Comments of the Los Angeles County Bar Association, at 2.
    \94\ Comments of Eleven Persons or Law Firms, at 8-9; Comments 
of the American Bar Association, at 33 (urging the Commission to 
refrain from considering the proposed disclosure provisions unless 
and until it receives express Congressional authority to preempt 
state privilege rules); Comments of 77 law firms, at 2; Comments of 
Latham & Watkins, at 5-6; Comments of Theodore Sonde, at 2; Comments 
of Schiff Hardin & Waite, at 7-8; Comments of Sheldon M. Jaffe, at 
7-9; Comments of Emerson Electric, at 2; Comments of the Federal Bar 
Council, at 9-10 & n.9; Comments of JP Morgan & Chase, at 11 & n.3 
(citing treatise for proposition that only six states permit 
disclosure to rectify past fraud).
    \95\ Comments of the Law Society of England and Wales, at 12.
---------------------------------------------------------------------------

    Other commenters noted that these disclosure provisions should be 
limited to illegal acts that are likely to have a material impact on 
the market for the issuer's securities,\96\ or to ongoing criminal or 
fraudulent conduct by the issuer,\97\ while others suggest that 
attorneys should only be permitted to disclose information where there 
is a risk of death or bodily harm, and not where only ``monetary 
interests'' are

[[Page 6311]]

involved.\98\ Many of the commenters voicing objections to this 
paragraph suggested that the Commission defer its promulgation until 
after further developments by state supreme courts \99\ or further 
discussion.\100\ Others, while criticizing the rule, noted that an 
attorney practicing before the Commission could comply with this 
permissive disclosure provision, but would have a duty to explain to 
the client at the outset this limitation on the ``normal'' duty of 
confidentiality.\101\
---------------------------------------------------------------------------

    \96\ Comments of the Los Angeles County Bar Association, at 2; 
Comments of Edward C. Brewer, III at 8; see also Comments of the 
Association of the Bar of the City of New York at 5 (supporting 
attorney disclosure of materials facts to avoid assisting a criminal 
or fraudulent act by the client, or to correct prior representations 
made by the lawyer and believed by the lawyer still to be relied 
upon by a third person where the lawyer has discovered that the 
opinion or representation was based on materially inaccurate 
information or is being used to further a crime or fraud).
    \97\ Comments of Theodore Sonde, at 2.
    \98\ Comments of the American College of Trial Lawyers, at 6.
    \99\ Comments of Conference of Chief Justices, at 4.
    \100\ Comments of the Federal Bar Council, at 14.
    \101\ Comments of the Law Society of England and Wales, at 12.
---------------------------------------------------------------------------

    Commenters supporting the paragraph, however, noted that at least 
four-fifths of the states now permit or require such disclosures as 
pertain to ongoing conduct,\102\ and that those states that follow the 
minority rule ``narrow[] the lawyer's options for responding to client 
conduct that could defraud investors and expose the lawyer to liability 
for legal work that the lawyer has already done.''\103\ Several of 
these comments noted that the Commission could or should have required 
that lawyers make these disclosures to it when the client insists on 
continuing fraud or pursuing future illegal conduct,\104\ and urged the 
Commission to make clear that this paragraph does not override state 
ethics rules that make such disclosures mandatory.\105\ Many commenters 
also stated that it was proper for this paragraph to preempt any state 
ethics rule that does not permit disclosure.\106\ They also noted that 
the confidentiality interests of a corporate client are not infringed 
by lawyer disclosure under the circumstances required by the paragraph, 
as the paragraph addresses a situation where the lawyer reasonably 
believes that agents of an issuer are engaged in serious illegality 
that the issuer has failed to remedy; in that situation, an instruction 
by an officer or even the board of the issuer to remain silent cannot 
be regarded as authorized.\107\ Others generally supported the 
provision as injecting vitality into existing ethics rules, and stated 
that the Commission should not delay action on this provision.\108\ One 
commenter emphasized the need to protect from retaliation attorneys who 
engage in the reporting mandated by Part 205.\109\
---------------------------------------------------------------------------

    \102\ Comments of Morrison & Foerster and eight other law firms, 
Exhibit B (listing jurisdictions whose ethics rules permit or 
require attorneys to disclose clients' past and/or require attorneys 
to disclose clients' past and/or ongoing fraud); Comments of Edward 
C. Brewer, III, at 8 (the proposed rule for permissive disclosure of 
an issuer's ``illegal act'' is essentially no different than the 
existing Model Code provision).
    \103\ Comments of Richard W. Painter, at 6.
    \104\ Comment of Edward C. Brewer, at 8.
    \105\ Comments of Susan P. Koniak et al., at 26-27; Comments of 
Nancy J. Moore, at 2-3.
    \106\ Comments of Susan P. Koniak et al., 27, 31-32.
    \107\ Comments of William H. Simon, at 3.
    \108\ See, e.g., Comments of Manning G. Warren III, at 1; 
Comments of Douglas A. Schafer, Comment of Elaine J. Mittleman at 2; 
Comments of Thomas Ross et al., at 6-8.
    \109\ Comment of Elaine J. Mittleman at 2.
---------------------------------------------------------------------------

    The final version of this paragraph contains modifications or 
clarifications of the paragraph as proposed. In paragraph (2), the 
description of when an attorney may disclose client confidences is 
limited ``to the extent the attorney reasonably believes necessary'' to 
accomplish one of the objectives in the rule. In subparagraph (i), the 
term ``material violation'' has been substituted for ``illegal act'' to 
conform to the statutory language in Section 307. In subparagraph (ii), 
the final version identifies the illegal acts that might perpetrate a 
fraud upon the Commission in an investigation or administrative 
proceeding; each of the statutes now referenced in subparagraph (ii) 
were referenced in the release accompanying the proposed rule.\110\ The 
term ``perpetrate a fraud'' in this paragraph covers conduct involving 
the knowing misrepresentation of a material fact to, or the concealment 
of a material fact from, the Commission with the intent to induce the 
Commission to take, or to refrain from taking, a particular action. 
Subparagraph (iii) has been modified to cover only material violations 
by the issuer, and now this material violation must be one that has 
``caused, or may cause, substantial injury to the financial interest or 
property of the issuer or investors'' before the provision may be 
invoked.
---------------------------------------------------------------------------

    \110\ See 67 FR at 71693.
---------------------------------------------------------------------------

    With regard to the issues raised by the comments on this paragraph, 
as explained below, the Commission either has addressed the concerns 
voiced by the commenters, believes that the concerns are adequately 
addressed by the paragraph, or has found the concerns to be 
insufficient to warrant further modification. Although commenters 
raised a concern that permitting attorneys to disclose information to 
the Commission without a client's consent would undermine the issuers' 
trust in their attorneys, the vast majority of states already permit 
(and some even require) disclosure of information in the limited 
situations covered by this paragraph,\111\ and the Commission has seen 
no evidence that those already-existing disclosure obligations have 
undermined the attorney-client relationship. In addition, the existing 
state law ethics rules support the proposition that generalized 
concerns about impacting the attorney-client relationship must yield to 
the public interest where an issuer seeks to commit a material 
violation that will materially damage investors, seek to perpetrate a 
fraud upon the Commission in enforcement proceedings, or has used the 
attorney's services to commit a material violation.
---------------------------------------------------------------------------

    \111\ Comment of the American Corporate Counsel Association, at 
7 (noting that permissive disclosure standards are ``more in line 
with a majority of state professional rules of conduct'').
---------------------------------------------------------------------------

    With regard to the comments that this paragraph would preempt state 
law ethics rules that do not permit disclosure of information 
concerning such acts, or the concerns expressed by commenters at the 
other end of the spectrum that this paragraph could be misread to 
supplant state ethics rules that require rather than permit 
disclosure,\112\ the Commission refers to Section 205.1 and the related 
discussion above. Section 205.1 makes clear that Part 205 supplements 
state ethics rules and is not intended to limit the ability of any 
jurisdiction to impose higher obligations upon an attorney not 
inconsistent with Part 205. A mandatory disclosure requirement imposed 
by a state would be an additional requirement consistent with the 
Commission's permissive disclosure rule. The Commission also notes 
that, as this paragraph in most situations follows the permissive 
disclosure rules already in place in most jurisdictions, the conflict 
raised by these commenters is unlikely to arise in practice.
---------------------------------------------------------------------------

    \112\ Specifically, New Jersey requires an attorney to reveal 
confidential ``information relating to the representation of a 
client to the proper authorities * * * to the extent the lawyer 
reasonably believes necessary to prevent the client: (1) [f]rom 
committing a criminal, illegal or fraudulent act that the lawyer 
reasonably believes is likely to result in * * * substantial injury 
to the financial interest or property of another'' or (2) such an 
act that ``the lawyer reasonably believes is likely to perpetrate a 
fraud upon a tribunal.'' New Jersey Rule of Professional Conduct 
1.6(b). Wisconsin's corresponding rule is virtually identical to New 
Jersey's, except that it makes no reference to ``proper 
authorities.'' Wisconsin Supreme Court Rule 20:1.6. Florida requires 
a lawyer to reveal confidential information ``to the extent the 
lawyer reasonably believes necessary * * * to prevent a client from 
committing a crime.'' Florida Rule of Professional Conduct 4-1.6.
---------------------------------------------------------------------------

    As for the comments suggesting that attorneys be permitted to 
disclose only information that would appear to have a material impact 
on the value of the issuer's securities, the Commission has,

[[Page 6312]]

where appropriate, modified the paragraph in a manner that responds to 
that concern. Subparagraph (iii) has been limited to material 
violations, and subparagraph (i) limits its application to material 
violations that are likely to cause substantial injury to the financial 
interest or property of the issuer or investors.
    Finally, the Commission concludes that it is not appropriate for it 
to wait for further developments. The Commission believes there has 
been ample discussion of this paragraph in the comments received, and 
that the major issues concerning this paragraph have been well 
identified. In addition, delay pending further developments does not 
promise to be fruitful: most state supreme courts already have rules in 
place that are consistent with this paragraph, and there is no evidence 
when, if ever, state supreme courts (or legislative bodies) will 
revisit these issues, and the public interest in allowing lawyers 
appearing and practicing before the Commission to disclose the acts 
covered by this paragraph counsels against waiting indefinitely for 
further refinement of state ethics rules.

Subsection 205.3(e)(3) in Proposed Rule: Withdrawn

    The proposed paragraph read:

    Where an issuer, through its attorney, shares with the 
Commission information related to a material violation, pursuant to 
a confidentiality agreement, such sharing of information shall not 
constitute a waiver of any otherwise applicable privilege or 
protection as to other persons.

    Several commenters stated that it was uncertain if the Sarbanes-
Oxley Act granted the Commission the authority to promulgate a rule 
that would control determinations by state and federal courts whether a 
disclosure to the Commission, even if conditioned on a confidentiality 
agreement, waives the attorney-client privilege or work product 
protection,\113\ and a few suggested that the proposed paragraph would 
conflict with Federal Rule of Evidence 501.\114\ They noted that this 
is an unsettled issue in the courts, or suggested that the Commission's 
proposed rule runs contrary to the bulk of decisional authority on this 
issue.\115\ A few also noted that proposed legislation before Congress 
in 1974, supported by the Commission, that would have enacted a 
provision permitting issuers to selectively waive privileges in 
disclosures to the Commission was ultimately not passed by 
Congress.\116\ The concern was expressed that attorneys might disclose 
information to the Commission in the belief that the evidentiary 
privileges for that information were preserved, only to have a court 
subsequently rule that the privilege was waived.\117\
---------------------------------------------------------------------------

    \113\ Comments of Richard W. Painter, at 9 (``the only effective 
method'' of assuring lawyers that the attorney-client privilege is 
not waived by disclosure to the Commission ``is to seek an act of 
Congress establishing selective waiver and preempting inconsistent 
state law''); Comments of the American Bar Association, at 32; 
Comments of Susan P. Koniak et al., at 44.
    \114\ Comments of Sheldon Jaffe, at 10. Fed. R. Evid. 501 
provides that ``[e]xcept as otherwise required by the Constitution 
of the United States or provided by Act of Congress or in rules 
prescribed by the Supreme Court pursuant to statutory authority, the 
privilege of a witness, person, government, State, or political 
subdivision thereof shall be governed by the principles of the 
common law as they may be interpreted by the courts of the United 
States in the light of reason and experience. However, in civil 
actions and proceedings, with respect to an element of a claim or 
defense as to which State law supplies the rule of decision, the 
privilege of a witness, person, government, State, or political 
subdivision thereof shall be determined in accordance with State 
law.''
    \115\ Comments of the American Bar Association, at 32 n. 21; 
Comments of Sheldon M. Jaffe, at 9-11; Comments of Edward C. Brewer, 
III, at 11; Comments of Latham & Watkins, at 5; Comments of Morrison 
& Foerster and eight other law firms, at 19.
    \116\ Comments of the American Bar Association, at 32 n. 22; 
Comments of Morrison & Foerster and eight other law firms, at 19. 
The Commission notes that the proposal in Congress to which these 
commenters refer would have applied the selective waiver doctrine to 
all documents produced to the Commission, and was not limited to 
productions conditioned upon an express confidentiality agreement. 
See Westinghouse Elec. Corp. v. Republic of the Philippines, 951 
F.2d 1414, 1425 (3d Cir. 1991). Also, Congress did not reject the 
Commission's proposal; rather, the House Committee to which the 
proposal was submitted took no action. See SEC Oversight and 
Technical Amendments: Hearing Before the Subcommittee on 
Telecommunications, Consumer Protection, and Finance of the House 
Committee on Energy and Commerce, 98th Cong., 2d Sess 341 at 34, 51 
(1984). Therefore, that the proposal before that House Committee in 
1984 was not ultimately enacted carries no significance. NAACP v. 
American Family Mut. Ins. Co., 978 F.2d 287, 299 (7th Cir. 1992) 
(``unsuccessful proposals to amend a law, in the years following 
passage, carry no significance'').
    \117\ Comments of Richard W. Painter, at 9; Comments of Susan P. 
Koniak et al., at 6; Comments of Latham & Watkins, at 5 (``[g]iven 
the high stakes associated with waiver of privilege, uncertainty as 
to interpretation of [Paragraph 205.3(e)(3)'s] requirements in this 
regard is troubling''); Comments of the SIA/TBMA at 15 (``[a]lthough 
we welcome this positive statement of Commission policy, given sharp 
disagreements among courts on the question of selective waiver, 
issuers and attorneys cannot be secure in their disclosures absent a 
statutory statement of express preemption'').
---------------------------------------------------------------------------

    The Commission has determined not to adopt the proposed rule on 
this ``selective waiver'' provision. The Commission is mindful of the 
concern that some courts might not adopt the Commission's analysis of 
this issue, and that this could lead to adverse consequences for the 
attorneys and issuers who disclose information to the Commission 
pursuant to a confidentiality agreement, believing that the evidentiary 
protections accorded that information remain preserved.
    Nonetheless, the Commission finds that allowing issuers to produce 
internal reports to the Commission--including those prepared in 
response to reports under 205.3(b)--without waiving otherwise 
applicable privileges serves the public interest because it 
significantly enhances the Commission's ability to conduct expeditious 
investigations and obtain prompt relief, where appropriate, for 
defrauded investors. The Commission further finds that obtaining such 
otherwise protected reports advances the public interest, as the 
Commission only enters into confidentiality agreements when it has 
reason to believe that obtaining the reports will allow the Commission 
to save substantial time and resources in conducting investigations 
and/or provide more prompt monetary relief to investors. Although the 
Commission must verify that internal reports are accurate and complete 
and must conduct its own investigation, doing so is far less time 
consuming and less difficult than starting and conducting 
investigations without the internal reports. When the Commission can 
conduct expeditious and efficient investigations, it can then obtain 
appropriate remedies for investors more quickly. The public interest is 
thus clearly served when the Commission can promptly identify illegal 
conduct and provide compensation to victims of securities fraud.
    The Commission also finds that preserving the privilege or 
protection for internal reports shared with the Commission does not 
harm private litigants or put them at any kind of strategic 
disadvantage. At worst, private litigants would be in exactly the same 
position that they would have been in if the Commission had not 
obtained the privileged or protected materials. Private litigants may 
even benefit from the Commission's ability to conduct more expeditious 
and thorough investigations. Indeed, many private securities actions 
follow the successful completion of a Commission investigation and 
enforcement action. Consequently, allowing the Commission access to 
otherwise privileged and inaccessible internal reports but denying 
access to others would not be unfair to private litigants but is 
appropriate in the public interest and for the protection of investors.
    For these reasons, the Commission will continue to follow its 
policy of

[[Page 6313]]

entering into confidentiality agreements where it determines that its 
receipt of information pursuant to those agreements will ultimately 
further the public interest, and will vigorously argue in defense of 
those confidentiality agreements where litigants argue that the 
disclosure of information pursuant to such agreements waives any 
privilege or protection.

Section 205.4--Responsibilities of Supervisory Attorneys

    (a) An attorney supervising or directing another attorney who is 
appearing and practicing before the Commission in the representation 
of an issuer is a supervisory attorney. An issuer's chief legal 
officer (or the equivalent thereof) is a supervisory attorney under 
this section.
    (b) A supervisory attorney shall make reasonable efforts to 
ensure that a subordinate attorney, as defined in Sec.  205.5(a), 
that he or she supervises or directs conforms to this part. To the 
extent a subordinate attorney appears and practices before the 
Commission in the representation of an issuer, that subordinate 
attorney's supervisory attorneys also appear and practice before the 
Commission.
    (c) A supervisory attorney is responsible for complying with the 
reporting requirements in Sec.  205.3 when a subordinate attorney 
has reported to the supervisory attorney evidence of a material 
violation.
    (d) A supervisory attorney who has received a report of evidence 
of a material violation from a subordinate attorney under Sec.  
205.3 may report such evidence to the issuer's qualified legal 
compliance committee if the issuer has duly formed such a committee.

    Section 205.4 prescribes the responsibilities of a supervisory 
attorney, and is based in part upon Rule 5.1 of the ABA's Model Rules, 
which (1) mandates that supervisory attorneys (including partners at 
law firms and attorneys exercising similar management responsibilities 
at law firms) must make reasonable efforts to ensure that attorneys at 
the firm conform to the Rules of Professional Conduct; and (2) provides 
that a supervisory attorney may be held liable for violative conduct by 
another attorney which he or she knowingly ratifies or which he or she 
fails to prevent when able to do so.
    Several commenters objected that the articulation of the 
responsibilities of supervisory attorneys included in the proposed rule 
rendered senior attorneys responsible for the actions of more junior 
attorneys whose activities they might not actually supervise or direct. 
For example, the ABA argued that defining a supervisory attorney to 
include individuals ``who have supervisory authority over another 
attorney'' would unfairly cover ``all partners in a law firm and even 
senior associates,'' many of whom might not exercise actual supervisory 
authority regarding, or have any involvement with, the matter in 
question.\118\ On the other hand, comments submitted by a distinguished 
group of academics stated that the sections of the proposed rule 
prescribing the responsibilities of supervisor and subordinate 
attorneys were ``necessary'' and appropriate.\119\
---------------------------------------------------------------------------

    \118\ See Comments of the American Bar Association, at 22-23. 
See also Comments of Skadden, Arps, Slate, Meagher & Flom, at 27 
(arguing that the section should be eliminated entirely, or, 
alternatively, ``narrowed to apply only to the supervisory attorney 
within a law firm or a law department who is directly responsible 
for the supervision of a subordinate attorney in connection with the 
representation of the issuer in the specific matter, regardless of 
whether the attorney supervises such subordinate attorney in other 
unrelated matters.'').
    \119\ See Comments of Susan P. Koniak et al., at 42.
---------------------------------------------------------------------------

    The language we adopt today confirms that a supervisory attorney to 
whom a subordinate attorney reports evidence of a material violation is 
responsible for complying with the reporting requirements prescribed 
under the rule. This language modifies the proposed rule by clarifying 
that only a senior attorney who actually directs or supervises the 
actions of a subordinate attorney appearing and practicing before the 
Commission is a supervisory attorney under the rule. A senior attorney 
who supervises or directs a subordinate on other matters unrelated to 
the subordinate's appearing and practicing before the Commission would 
not be a supervisory attorney under the final rule. Conversely, an 
attorney who typically does not exercise authority over a subordinate 
attorney but who does direct the subordinate attorney in the specific 
matter involving the subordinate's appearance and practice before the 
Commission is a supervisory attorney under the final rule. The final 
rule eliminates the proposed requirement that a supervisory attorney 
who believes that evidence of a material violation presented by a 
subordinate attorney need not be reported ``up-the-ladder'' document 
the basis for that conclusion. The final rule also eliminates the 
requirement that a supervisory attorney ensure a subordinate's 
compliance with the federal securities laws.

Section 205.5--Responsibilities of a Subordinate Attorney

    (a) An attorney who appears and practices before the Commission 
in the representation of an issuer on a matter under the supervision 
or direction of another attorney (other than under the direct 
supervision or direction of the issuer's chief legal officer (or the 
equivalent thereof)) is a subordinate attorney.
    (b) A subordinate attorney shall comply with this part 
notwithstanding that the subordinate attorney acted at the direction 
of or under the supervision of another person.
    (c) A subordinate attorney complies with Sec.  205.3 if the 
subordinate attorney reports to his or her supervising attorney 
under Sec.  205.3(b) evidence of a material violation of which the 
subordinate attorney has become aware in appearing and practicing 
before the Commission.
    (d) A subordinate attorney may take the steps permitted or 
required by Sec.  205.3(b) or (c) if the subordinate attorney 
reasonably believes that a supervisory attorney to whom he or she 
has reported evidence of a material violation under Sec.  205.3(b) 
has failed to comply with Sec.  205.3.

    Section 205.5 is based, in part, on Rule 5.2 of the ABA's Model 
Rules (which provides that subordinate attorneys remain bound by the 
Model Rules notwithstanding the fact that they acted at the direction 
of another person). This section confirms that a subordinate attorney 
is responsible for complying with the rule. We do not believe that a 
subordinate attorney should be exempted from the application of the 
rule merely because he or she operates under the supervision or at the 
direction of another person. We believe that creation of such an 
exemption would seriously undermine Congress' intent to provide for the 
reporting of evidence of material violations to issuers. Indeed, 
because subordinate attorneys frequently perform a significant amount 
of work on behalf of issuers, we believe that subordinate attorneys are 
at least as likely (indeed, potentially more likely) to learn about 
evidence of material violations as supervisory attorneys.
    This section attracted far less comment than section 205.4, and 
those comments which were received typically supported the concept of 
allowing a subordinate attorney to satisfy his or her obligations under 
the rule by reporting evidence of a material violation to a supervisory 
attorney.\120\ The language we adopt today clarifies that a subordinate 
attorney must be appearing and practicing before the Commission to come 
under the rule, and conforms this section to the language in section 
205.4 by providing that a senior attorney must actually direct or 
supervise the actions of a subordinate attorney (rather than have

[[Page 6314]]

supervisory authority) to be a supervisory attorney under the rule.
---------------------------------------------------------------------------

    \120\ See Comments of the American Bar Association, at 22 (``We 
believe the Commission correctly approaches in Rule 205.5 the 
treatment of subordinate lawyers who report to a supervisory 
attorney and in Rule 205.4(c) the shifting of responsibility for 
compliance to the supervisory attorney to which the matter was 
reported'').
---------------------------------------------------------------------------

    New language has been added to this section to provide that an 
attorney who appears and practices before the Commission on a matter in 
the representation of an issuer under the supervision or direction of 
the issuer's CLO (or the equivalent thereto) is not a subordinate 
attorney. Accordingly, that person is required to comply with the 
reporting requirements of Section 205.3. For example, an issuer's 
Deputy General Counsel, who reports directly to the issuer's General 
Counsel (CLO) on a matter before the Commission, is not a subordinate 
attorney. Thus, the Deputy General Counsel is not relieved of any 
further reporting obligations by advising the CLO of evidence of a 
material violation. Further, in the event the Deputy General Counsel 
does not receive an appropriate response from the CLO, he or she is 
obligated to report further up-the-ladder within the issuer.

Section 205.6--Sanctions and Discipline

    (a) A violation of this part by any attorney appearing and 
practicing before the Commission in the representation of an issuer 
shall subject such attorney to the civil penalties and remedies for 
a violation of the federal securities laws available to the 
Commission in an action brought by the Commission thereunder.
    (b) An attorney appearing and practicing before the Commission 
who violates any provision of this part is subject to the 
disciplinary authority of the Commission, regardless of whether the 
attorney may also be subject to discipline for the same conduct in a 
jurisdiction where the attorney is admitted or practices. An 
administrative disciplinary proceeding initiated by the Commission 
for violation of this part may result in an attorney being censured, 
or being temporarily or permanently denied the privilege of 
appearing or practicing before the Commission.
    (c) An attorney who complies in good faith with the provisions 
of this part shall not be subject to discipline or otherwise liable 
under inconsistent standards imposed by any state or other United 
States jurisdiction where the attorney is admitted or practices.
    (d) An attorney practicing outside the United States shall not 
be required to comply with the requirements of this part to the 
extent that such compliance is prohibited by applicable foreign law.

    Paragraph 205.6(a) of the proposed rule tracked the language of 
Section 3(b) of the Act (which expressly states that a violation of the 
Act and rules promulgated thereunder shall be treated as a violation of 
the Exchange Act, subjecting any person committing such a violation to 
the same penalties as are prescribed for violations of the Exchange 
Act). Similarly, paragraph 205.6(b) of the proposed rule was based on 
Section 602 of the Act (adding Section 4C(a) to the Exchange Act, which 
incorporates that portion of Rule 102(e) of the Commission's Rules of 
Practice prescribing the state-of-mind requirements for Commission 
disciplinary actions against accountants who engage in improper 
professional conduct). Finally, paragraph 205.6(c) of the proposed rule 
stated that the Commission may discipline attorneys who violate the 
rule, regardless of whether the attorney is subject to prosecution or 
discipline for violation of a state ethical rule that applies to the 
same conduct.
    Collectively, proposed section 205.6 (originally entitled 
``Sanctions'') generated a number of comments. One commenter complained 
that sections 3(b) and 307 of the Act did not authorize Commission 
enforcement action against violators of the rule, and that violations 
should be handled in Commission disciplinary proceedings.\121\ Several 
other commenters argued that paragraph 205.6(a) should specifically 
state that the Commission will not seek criminal penalties for 
violations of the rule.\122\ Commenters also suggested that the 
juxtaposition of paragraphs 205.6(a) and (b) created confusion as to 
whether the Commission would treat violations of the rule as an 
Exchange Act violation or a violation of Rule 102(e). A number of 
commenters also suggested that the Commission should create a safe 
harbor, protecting attorneys who make a good faith attempt to comply 
with the rule and explicitly stating that the rule is only enforceable 
by the Commission and does not create a private right of action.\123\
---------------------------------------------------------------------------

    \121\ See Comments of the Association of the Bar of the City of 
New York, at 43-44.
    \122\ Id. at 46-47. See also Comments of Morrison & Foerster and 
eight other law firms, at 21.
    \123\ See Comments of Skadden, Arps, Slate, Meagher and Flom, at 
29; Comments of the SIA/TBMA, at 16; Comments of the American Bar 
Association, at 33; Comments of Sullivan & Cromwell, at 16-17.
---------------------------------------------------------------------------

    The language we today adopt in Sec.  205.6 has been extensively 
modified in light of these comments. The amended section is now titled 
``Sanctions and Discipline,'' emphasizing that the Commission intends 
to proceed against individuals violating Part 205 as it would against 
other violators of the federal securities laws and, when appropriate, 
to initiate proceedings under this rule seeking an appropriate 
disciplinary sanction. Paragraph 205.6(a) has been amended to clarify 
that only the Commission may bring an action for violation of the part. 
Paragraph 205.6(b) incorporates the language of paragraph 205.6(c) of 
the proposed rule, and adds new language specifying the sanctions 
available to the Commission in administrative disciplinary proceedings 
against attorneys who violate the part.
    New paragraph 205.6(c), consistent with Sec.  205.1, provides that 
attorneys who comply in good faith with this part shall not be subject 
to discipline for violations of inconsistent standards imposed by a 
state or other United States jurisdiction. Paragraph 205.6(c) has been 
drafted to apply only to an attorney's liability for violating 
inconsistent standards of a state or other U.S. jurisdiction. Thus, it 
is not available where the state or other jurisdiction imposes 
additional requirements on the attorney that are consistent with the 
Commission's rules. Moreover, this paragraph has no application in 
actions or proceedings brought by the Commission relating to violations 
of the federal securities laws or the Commission's rules or regulations 
thereunder. Further, the fact that an attorney may assert or establish 
in a state professional disciplinary proceeding, or in a private 
action, that he or she complied with this part, and complied in good 
faith, does not affect the Commission's ability or authority to bring 
an enforcement action or disciplinary proceeding against an attorney 
for a violation of this part. Indeed, even if a state ethics board or a 
court were to determine in an action not brought by the Commission that 
an attorney complied with this part or complied in good faith with this 
part, that determination would not preclude the Commission from 
bringing either an enforcement action or a disciplinary proceeding 
against that attorney for a violation of this part based on the same 
conduct.
    New paragraph 205.6(d) addresses the conduct of non-U.S. attorneys 
who are subject to this part, because they do not meet the definition 
of non-appearing foreign attorney. As noted above, the new definition 
of non-appearing foreign attorney in paragraph 205.2(j) responds to the 
large number of comments received from lawyers practicing in other 
jurisdictions stating that attorneys practicing in many foreign 
countries are subject to rules and regulations that render compliance 
with the part impossible. This point was also made at the December 17 
Roundtable discussion. Several commenters also stated that attorneys 
who are admitted in United States jurisdictions but who practice in 
foreign countries are subject to similar restrictions. New paragraph 
205.6(d) provides that attorneys in that situation must comply with the 
part to the

[[Page 6315]]

maximum extent allowed by the regulations and laws to which they are 
subject.

Section 205.7--No Private Right of Action

    (a) Nothing in this part is intended to, or does, create a 
private right of action against any attorney, law firm, or issuer 
based upon compliance or noncompliance with its provisions.
    (b) Authority to enforce compliance with this part is vested 
exclusively in the Commission.

    In the proposing release, the Commission expressed its view that: 
``nothing in Section 307 creates a private right of action against an 
attorney. * * * Similarly, the Commission does not intend that the 
provisions of Part 205 create any private right of action against an 
attorney based on his or her compliance or non-compliance with its 
provisions.''\124\ Nevertheless, the Commission requested comments on 
whether it should provide in the final rule ``a `safe harbor' from 
civil suits'' for attorneys who comply with the rule.\125\ Numerous 
commenters agreed that the final rule should contain such a provision.
---------------------------------------------------------------------------

    \124\ 67 FR 71697.
    \125\ 67 FR 71691.
---------------------------------------------------------------------------

    Several commenters suggested that the final rule contain a safe 
harbor similar to that provided for auditors in Section 10A(c) of the 
Exchange Act, 15 U.S.C. 78j-1(c), which provides that ``[n]o 
independent public accountant shall be liable in a private action for 
any finding, conclusion, or statement expressed in a report'' to the 
Commission made by an issuer whose auditor has reported to its board a 
failure to take remedial action.\126\ Other commenters recommended that 
the Commission adopt language similar to that in the Restatement 
(Third) of Law Governing Lawyers, Standards of Care section 52, which 
provides that ``[p]roof of a violation of a rule or statute regulating 
the conduct of lawyers * * * does not give rise to an implied cause of 
action for professional negligence or breach of fiduciary duty * * * 
.'' \127\ And others noted that the ABA Model Rules, Scope, [para] 20, 
provides that ``[v]iolation of Rule should not itself give rise to a 
cause of action against a lawyer nor should it create any presumption 
in such a case that a legal duty has been breached.'' \128\ Finally, 
numerous other commenters were of the view that a safe harbor should be 
created to protect lawyers from liability where they have attempted in 
good faith to comply with this part.\129\
---------------------------------------------------------------------------

    \126\ See Comments of Attorney's Liability Assurance Society, 
Inc., at 20; Comments of the Association of the Bar of the City of 
New York, at 5.
    \127\ See Comments of the American Bar Association, at 33-34; 
Comments of Morrison & Foerster and eight other law firms, at 21.
    \128\ Id. Comments of the American Bar Association, at 33-34.
    \129\ See, e.g., Comments of Skadden Arps Slate Meagher & Flom, 
at 29; Comments of the SIA/TBMA, at 21; Comments of the Investment 
Company Institute, at 7.
---------------------------------------------------------------------------

    The Commission is persuaded that it is appropriate to include an 
express safe harbor provision in the rule, which is set forth in new 
Section 205.7, No Private Right of Action. Paragraph (a) makes it clear 
that Part 205 does not create a private cause of action against an 
attorney, a law firm or an issuer, based upon their compliance or non-
compliance with the part. The Commission is of the view that the 
protection of this provision should extend to any entity that might be 
compelled to take action under this part; thus it extends to law firms 
and issuers. The Commission is also of the opinion that, for the safe 
harbor to be truly effective, it must extend to both compliance and 
non-compliance under this part.
    Paragraph (b) provides that only the Commission may enforce the 
requirements of this part. The provision is intended to preclude, among 
other things, private injunctive actions seeking to compel persons to 
take actions under this part and private damages actions against such 
persons. Once again, the protection extends to all entities that have 
obligations under this part.

III. Paperwork Reduction Act

    The Paperwork Reduction Act of 1995 (``PRA'')\130\ requires the 
agency to obtain approval from the Office of Management and Budget 
(``OMB'') if an agency's rule would require a ``collection of 
information,'' as defined by the PRA. As set forth in the proposing 
release, certain provisions of the rule, such as the requirement of 
written procedures for QLCCs, meet the ``collection of information'' 
requirement of the PRA. The information collection is necessary to 
implement the Standards of Professional Conduct for Attorneys 
prescribed by the proposed rule and required by Section 307 of the 
Sarbanes-Oxley Act of 2002. Specifically, the collection of information 
is intended to ensure that evidence of violations is communicated to 
appropriate officers and/or directors of issuers, so that they can 
adopt appropriate remedies and/or impose appropriate sanctions. In the 
rare cases in which a majority of a QLCC has concluded that an issuer 
did not act appropriately, the information may be communicated to the 
Commission. The collection of information is, therefore, an important 
component of the Commission's program to discourage violations of the 
federal securities laws and promote ethical behavior of attorneys 
appearing and practicing before the Commission.
---------------------------------------------------------------------------

    \130\ 44 U.S.C. 3501 et seq.
---------------------------------------------------------------------------

    The final rule would impose an up-the-ladder reporting requirement 
when attorneys appearing and practicing before the Commission become 
aware of evidence of a material violation by the issuer or any officer, 
director, employee, or agent of the issuer. An attorney must report 
such evidence to the issuer's CLO or to both the CLO and CEO. A 
subordinate attorney complies with the rule if he or she reports 
evidence of a material violation to his or her supervisory attorney 
(who is then responsible for complying with the rule's requirements). A 
subordinate attorney may also take the other steps described in the 
rule if the supervisor fails to comply.
    If the CLO, after investigation, determines that there is no 
violation, he or she must so advise the reporting attorney. Unless the 
CLO reasonably believes that there is no violation, he or she must take 
reasonable steps to cause the issuer to adopt an appropriate response 
to stop, prevent or rectify any violation. The CLO must also report on 
the remedial measures or sanctions to the reporting attorney.
    The rule also requires attorneys to take certain steps if the CLO 
or CEO does not provide an appropriate response to a report of evidence 
of a violation. These steps include reporting the evidence up-the-
ladder to the audit committee, another committee consisting solely of 
independent directors if there is no audit committee, or to the board 
of directors if there is no such committee. If the attorney believes 
that the issuer has not made an appropriate response to the report, the 
attorney must explain the reasons for his or her belief to the CEO, CLO 
or directors to whom the report was made.
    Alternatively, if an attorney other than a CLO reports the evidence 
to a QLCC, he or she need take no further action under the rule. The 
QLCC must have written procedures for the receipt, retention and 
consideration of reports of material violations, and must be authorized 
and responsible to notify the CLO and CEO of the report, determine 
whether an investigation is necessary and, if so, to notify the audit 
committee or the board of directors. The QLCC may also initiate an 
investigation to be

[[Page 6316]]

conducted by the CLO or outside attorneys, and retain any necessary 
expert personnel. At the conclusion of the investigation, the QLCC may 
recommend that the issuer adopt appropriate remedial measures and/or 
impose sanctions, and notify the CLO, CEO, and board of directors of 
the results of the inquiry and appropriate remedial measures to be 
adopted. Where the QLCC decides, by a majority vote, that the issuer 
has failed to take any remedial measure that the QLCC has directed the 
issuer to take, the QLCC has the authority to notify the Commission. A 
CLO may also refer a report of evidence of a material violation to a 
QLCC, which then would have responsibility for taking the steps 
required by the rule.
    The respondents to this collection of information would be 
attorneys who appear and practice before the Commission and, in certain 
cases, the issuer, and/or officers, directors and committees of the 
issuer. We proposed to require attorneys to document communications 
contemplated by the proposed rule. In response to commenters concerns, 
we are not specifying that the communications must be documented. We 
continue to believe that, in providing quality representation to 
issuers, attorneys report evidence of violations to others within the 
issuer, including the CLO, the CEO, and, where necessary, the 
directors. In addition, officers and directors already investigate 
evidence of violations and report within the issuer the results of the 
investigation and the remedial steps they have taken or sanctions they 
have imposed. Attorneys who believe that they were discharged for 
making a report under the proposed rule might notify the issuer of that 
fact. Except as discussed below, we therefore believe that the 
reporting requirements imposed by the rule are ``usual and customary'' 
activities that do not add to the burden that would be imposed by the 
collection of information.\131\
---------------------------------------------------------------------------

    \131\ See 5 CFR 1320.3(b)(2).
---------------------------------------------------------------------------

    Certain aspects of the collection of information, however, impose a 
new burden. For an issuer to choose to establish a QLCC, the QLCC must 
adopt written procedures for the confidential receipt, retention and 
consideration of any report of evidence of a material violation. We are 
adopting this requirement and its collection of information requirement 
largely as proposed.
    We estimate for purposes of the PRA that there are approximately 
18,200 issuers that would be subject to the proposed rule.\132\ We are 
unable to estimate precisely how many issuers will choose to form a 
QLCC. For these purposes, we estimate that approximately 20%, or 3,640, 
will choose to establish a QLCC. Establishing the written procedures 
required by the proposed rule should not impose a significant burden. 
We assume that an issuer would incur a greater burden in the year that 
it first establishes the procedures than in subsequent years, in which 
the burden would be incurred in updating, reviewing, or modifying the 
procedures. For purposes of the PRA, we assume that an issuer would 
spend six hours every three-year period on the procedures. This would 
result in an average burden of two hours per year. Thus, we estimate 
for purposes of the PRA that the total annual burden imposed by this 
collection of information would be 7,280 hours. We assume that half of 
those hours will be incurred by outside counsel at a rate of $300 per 
hour. Using these assumptions, we estimate the collection of 
information would result in a cost of $1,092,000.
---------------------------------------------------------------------------

    \132\ This estimate is based, in part, on the total number of 
operating companies that filed annual reports on Form 10-K (8,484), 
Form 10-KSB (3,820), Form 20-F (1,194) or Form 40-F (134) during the 
2001 fiscal year, and an estimate of the average number of issuers 
that may have a registration statement filed under the Securities 
Act pending with the Commission at any time (100). In addition, we 
estimate that approximately 4,500 investment companies currently 
file periodic reports on Form N-SAR.
---------------------------------------------------------------------------

    We are not adopting at this time a requirement that attorneys make 
a ``noisy withdrawal.'' We have amended the PRA submission to remove 
any burden from that collection of information. We are still 
considering that provision and, in a separate proposing release, we are 
requesting additional comments on it. In addition, we are separately 
proposing an alternative that, along with the ``noisy withdrawal'' 
proposal, also constitutes a collection of information under the PRA.
    The Commission received two comments regarding the Paperwork 
Reduction Act section of the proposing release. One commenter indicated 
that the Commission has not considered the paperwork burdens of Part 
205 on attorneys who do not specialize in securities law, but who may 
be considered to be appearing and practicing before the Commission 
under the rule.\133\ The Commission believes that as adopted, the rule 
imposes little, if any, paperwork burdens on attorneys regardless of 
whether they specialize in securities law, especially in light of 
clarification to the rule's scope in the definition of ``appearing and 
practicing.'' Another commenter suggested that the Commission's 
original estimate that one quarter of the 18,200 issuers subject to the 
rule will form QLCCs may be understated, but offered no alternate 
estimate.\134\ The Commission estimated in the proposing release that 
one quarter of issuers would form QLCCs and received comments 
suggesting both that it would be difficult to find people to serve on 
QLCCs \135\ and, on the other hand, many companies would use 
QLCCs.\136\ Moreover, the Commission is not adopting at this time the 
``noisy withdrawal'' proposal, which may tend to cause fewer companies 
to form QLCCs. Accordingly, the Commission estimates that under the 
rule, as adopted, 20% of issuers will form QLCCs.
---------------------------------------------------------------------------

    \133\ Comments of the Mid-America Legal Foundation, at 3-4.
    \134\ Comments of Robert Eli Rosen, at 3.
    \135\ Comments of Clifford Chance, at 4-5; Comments of Emerson 
Electric Co., at 5.
    \136\ Comments of Susan P. Koniak et al., at 11; Comments of 
Richard W. Painter, at 5; Comments of Thomas D. Morgan, at 12.
---------------------------------------------------------------------------

    The Commission submitted the collection of information to OMB for 
review in accordance with 44 U.S.C. 3507(d) and 5 CFR 1320.11, under 
the title of ``Reports of Evidence of Material Violations.'' Because of 
the changes to the nature of the information collected and because of 
the separate proposal for an alternative to ``noisy withdrawal,'' we 
have changed the name of the submission to ``QLCC and Other Internal 
Reporting.'' OMB has not yet approved the collection; we will 
separately publish the OMB control number. An agency may not conduct or 
sponsor, and a person is not required to respond to, a collection of 
information unless it displays a currently valid control number. 
Compliance with the collection of information requirements is in some 
cases mandatory and in some cases voluntary depending upon the 
circumstances. Responses to the requirements to make disclosures to the 
Commission will not be kept confidential.

IV. Costs and Benefits

    Part 205 implements Section 307 of the Sarbanes-Oxley Act. Part 205 
will affect all attorneys who appear and practice before the Commission 
in the representation of an issuer and who become aware of evidence 
that tends to show that a material violation of federal or state 
securities laws, a material breach of fiduciary duty, or a similar 
material violation by the issuer or an officer, director, agent, or 
employee of

[[Page 6317]]

the issuer has occurred, is ongoing, or is about to occur. The rule we 
are issuing today implements a Congressional mandate to prescribe 
``minimum standards of professional conduct for attorneys appearing and 
practicing before the Commission in any way in the representation of 
issuers * * * .'' Prior to passage of the Sarbanes-Oxley Act, attorneys 
appearing and practicing before the Commission were regulated as to 
their professional conduct primarily by the ethics standards of the 
various states where attorneys happened to practice. By passing the 
Sarbanes-Oxley Act, Congress has implicitly concluded that the benefits 
of setting such minimum federal standards justify their costs. We 
enumerate and discuss these costs and benefits below.
    Part 205 implements an up-the-ladder reporting requirement upon 
attorneys representing an issuer before the Commission who become aware 
of a potential material violation about which a reasonably prudent 
investor would want to be informed. It is expected that, in the vast 
majority of instances of such reports, the situation will be addressed 
and remedied before it causes significant harm to investors.
    In addition to these requirements, the rule would authorize a 
covered attorney to reveal to the Commission confidences or secrets 
relating to the attorney's representation of an issuer before the 
Commission to the extent the attorney reasonably believes it necessary 
to: (i) Prevent the issuer from committing a material violation likely 
to cause substantial harm to the financial interest or property of the 
issuer or investors; (ii) prevent the issuer from perpetrating a fraud 
upon the Commission; or (iii) rectify the consequences of the issuer's 
illegal act that the attorney's services had furthered.

A. Benefits

    Part 205 is designed to protect investors and increase their 
confidence in public companies by ensuring that attorneys who represent 
issuers report up the corporate ladder evidence of material violations 
by their officers and employees. The Commission recognizes that some 
attorneys may already follow up-the-ladder reporting procedures, 
especially where the conduct at issue is directly related to the matter 
on which the attorney represents the issuer, but believes it will prove 
beneficial if all attorneys who appear and practice before the 
Commission comply with this requirement.
    Part 205 should protect investors by helping to prevent instances 
of significant corporate misconduct and fraud. The rule requires that 
attorneys report up-the-ladder when they become aware of evidence of a 
material violation. Although many attorneys already do this, some may 
not, especially if the violation is unrelated to the purpose for which 
they were retained. The rule gives issuers the option of forming a 
QLCC, consisting of at least one member of the issuer's audit committee 
and two or more independent directors, which would investigate reports 
of material violations and would be authorized to recommend that the 
issuer adopt appropriate remedial measures. The Commission believes 
that these requirements will make it more likely that companies will 
address instances of misconduct internally, and act to remedy 
violations at earlier stages.
    Part 205 is intended to increase investor confidence. By requiring 
attorneys to report potential misconduct up-the-ladder within a 
corporation, the rule provides a measure of comfort to investors that 
evidence of fraud will be known and evaluated by the top authorities in 
a corporation, including its board of directors, and not dismissed by 
lower-level employees. Furthermore, investors will know that a company 
that forms a QLCC will have reports of misconduct evaluated by at least 
one member of the company's audit committee as well as two or more of 
its independent directors. Investors will also know that if an issuer 
fails to implement a recommendation that the QLCC has recommended, the 
QLCC, after a majority vote, may notify the Commission.
    Part 205 should serve to deter corporate misconduct and fraud. 
Corporate wrongdoers at the lower or middle levels of the corporate 
hierarchy will be aware that an attorney who becomes aware of their 
misconduct is obligated under the rule to report it up-the-ladder to 
the highest levels of the corporation. In the event that wrongdoing or 
fraud exists at the highest levels of a corporation, those committing 
the misconduct will similarly know that the corporation's attorneys are 
obligated to report any misconduct of which they become aware up-the-
ladder to the corporation's board and its independent directors.
    Part 205 may improve the governance of corporations that are 
subject to the rule. By mandating up-the-ladder reporting of 
violations, the rule helps to ensure that evidence of material 
violations will be addressed and remedied within the corporation, 
rather than misdirected or ``swept under the rug.'' The formation of 
QLCCs may also serve to improve corporate governance. The Commission 
believes that some issuers will choose to adopt QLCCs, and that they 
may prove to be a recognized and effective means of reviewing reported 
evidence of material violations. Because a QLCC must consist of at 
least two independent directors (as well as one member of the 
corporation's audit committee), it will give greater authority to 
independent directors. This should serve as an important check on 
corporate management.
    Part 205 will give attorneys who appear and practice before the 
Commission guidance and clarity regarding their ethical obligations 
when confronted with evidence of wrongdoing by their clients. Part 205 
requires that attorneys report up-the-ladder when they become aware of 
potential material violations and thus complies with an express 
Congressional directive to set minimum standards of professional 
conduct for attorneys who appear and practice before it. These benefits 
are difficult to quantify.

B. Costs

    Part 205 will impose costs on issuers and law firms representing 
them. For issuers, the rule will require the chief legal officer of an 
issuer to investigate and, where necessary, cause remedial actions and/
or sanctions to be taken and/or imposed. It also will cause the CEO, 
QLCC, and board of directors of the issuer to review evidence of 
material violations. We believe that most issuers already have 
procedures for reviewing evidence of misconduct. Similarly, we expect 
that most issuers already incur costs with investigating such reports.
    Those companies that choose to form a QLCC to implement this 
provision will incur costs. These costs might include increased 
compensation and insurance for QLCC members, and administrative costs 
to establish the committee. Additionally, for purposes of the PRA, we 
assume that 20% of issuers will form such a committee and incur an 
annualized paperwork cost of two hours for a total annual burden of 
7,280 hours. Assuming outside counsel accounts for half of these hours 
at a cost of $300 per hour,\137\ and inside counsel accounts for the 
other half at $110 per hour,\138\ this would result in a cost of 
$1,492,400.
---------------------------------------------------------------------------

    \137\ Estimate of outside counsel rate was obtained by 
contacting a number of law firms regularly involved in completing 
Commission documents. See Disclosure Required by Sections 406 and 
407 of the Sarbanes-Oxley Act of 2002, Release Nos. 33-8138 (Oct. 
22, 2002) and 33-8177 at n.69 (Jan. 23, 2003).
    \138\ Estimate of inside counsel rate is derived from the 
Securities Industry Association ``Report on Management & 
Professional Earnings in the Securities Industry 2002,'' and 
represents the SIA value for an Assistant General Counsel in New 
York City.

---------------------------------------------------------------------------

[[Page 6318]]

    For lawyers, the rule could have an effect upon malpractice 
insurance premiums, which could, in turn, increase the cost of attorney 
services to issuers. The Commission received three comments suggesting 
that the rule, and particularly the provisions requiring mandatory 
withdrawal and reporting to the Commission, would lead to an increase 
in the number of malpractice suits brought against attorneys.\139\ One 
of these comments, from an insurance carrier, indicated that the rule 
could cause malpractice insurance premiums for attorneys to rise by 10% 
to 50%.\140\ The Commission has made a number of changes to the rule in 
light of these comments. The Commission has clarified and made explicit 
in Section 205.7 that no private right of action exists based on 
compliance or non-compliance with the rule. In addition, the Commission 
has made it clear in Section 205.6(c) that an attorney who complies in 
good faith with the rule will not be subject to discipline or otherwise 
liable under an inconsistent state standard. Moreover, the rule, as 
adopted, will not require attorneys to withdraw or report to the 
Commission, but will only require reporting to the Commission in the 
very limited circumstances occurring when a majority of a QLCC 
determines that an issuer has failed to take remedial action that was 
directed by the QLCC. Accordingly, the Commission believes that the 
rule will not have as great an effect on malpractice insurance premiums 
as suggested by commenters in response to the proposed rule.
---------------------------------------------------------------------------

    \139\ Comments of Chubb Specialty Insurance, at 2-3; Comments of 
the American Bar Association, at 26-7; Comments of Attorneys' 
Liability Assurance Society, Inc., at 8, 11.
    \140\ Comments of Chubb Specialty Insurance, at 5.
---------------------------------------------------------------------------

    Part 205 may also encourage some issuers to handle more legal 
matters in-house and may cause other issuers to limit the use of in-
house counsel and rely more heavily on outside counsel, possibly 
increasing the cost of legal services. The Commission received one 
comment indicating that issuers would refer more matters to in-house 
counsel \141\ and four comments indicating that the rule would result 
in more matters referred to outside counsel.\142\ None of the 
commenters attempted to quantify the costs associated with these 
shifts. To the extent that the rule, as originally proposed, provided 
some perceived incentives to transfer functions to or from outside 
counsel, principally because of the ``noisy withdrawal'' requirements, 
we believe that those perceived incentives are not present in the rule 
as adopted.
---------------------------------------------------------------------------

    \141\ Comments of Carter, Ledyard & Milburn, at 2.
    \142\ Comments of Committee on Investment Management Regulation, 
Association of the Bar of the City of New York, at 4; Comments of 
the American Corporate Counsel Association, at 4-5; Comments of 
Investment Company Institute, at 4; Comments of Debra M. Brown, at 
2.
---------------------------------------------------------------------------

    There may also be some additional costs of the rule imposed on the 
market that are exceedingly difficult to predict or quantify. The 
Commission received comments indicating that the rule, and particularly 
the proposal regarding ``noisy withdrawal,'' would cause issuers to be 
less willing to seek legal advice and would result in issuers being 
less forthcoming with their counsel.\143\ However, no commenters 
presented data or attempted to quantify any costs associated with this 
effect. The Commission also received comments indicating that the rule 
would not cause any decrease in attorney-client communication.\144\ 
Since the rule, as adopted, will not require mandatory withdrawal or 
disclosure to the Commission, we believe that Part 205 will not have 
any adverse impact on attorney-client communications.
---------------------------------------------------------------------------

    \143\ See, e.g., Comments of the American Bar Association, at 
26.
    \144\ See, e.g., Comments of Susan P. Koniak et al., at 24.
---------------------------------------------------------------------------

V. Effect on Efficiency, Competition and Capital Formation

    Section 23(a)(2) of the Exchange Act (15 U.S.C. 78w(a)(2)) requires 
us, when adopting rules under the Exchange Act, to consider the impact 
that any new rule would have on competition. Section 23(a)(2) prohibits 
us from adopting any rule that would impose a burden on competition not 
necessary or appropriate in furtherance of the purposes of the Exchange 
Act. In addition, Section 2(b) of the Securities Act (15 U.S.C. 
77b(b)), Section 3(f) of the Exchange Act (15 U.S.C. 78c(f)), and 
Section 2(c) of the Investment Company Act (15 U.S.C. 80a-2(c)), 
require us, when engaging in rulemaking where we are required to 
consider or determine whether an action is necessary or appropriate in 
the public interest, to consider, in addition to the protection of 
investors, whether the action will promote efficiency, competition and 
capital formation.
    Part 205 is intended to ensure that attorneys representing issuers 
before the Commission are governed by standards of conduct that 
increase disclosure of potential impropriety within an issuer so that 
prompt intervention and remediation can take place. Doing so should 
boost investor confidence in the financial markets. We anticipate that 
this rule will enhance the proper functioning of the capital markets 
and promote efficiency by reducing the likelihood that illegal behavior 
would remain undetected and unremedied for long periods of time. Part 
205 will apply to all issuers and attorneys appearing before the 
Commission and is therefore unlikely to affect competition.
    The Commission invited comment on this analysis, and received one 
comment on it.\145\ The commenter suggested that the rule could result 
in a large quantity of information being sent to a CLO or QLCC, which 
would be expensive and unwieldy to process, and would thus conflict 
with the goal of promoting efficiency, competition and capital 
formation. The Commission believes that Part 205 is consistent with the 
statutory goals and will substantially assist in attaining them by 
preventing corporate misconduct, restoring investor confidence and 
lowering the cost of capital.
---------------------------------------------------------------------------

    \145\ Comments of Los Angeles County Bar Association, at 7-8.
---------------------------------------------------------------------------

VI. Final Regulatory Flexibility Analysis

    This Final Regulatory Flexibility Analysis (``FRFA'') has been 
prepared in accordance with the Regulatory Flexibility Act, 5 U.S.C. 
601. An Initial Regulatory Flexibility Analysis (``IRFA'') was prepared 
in accordance with 5 U.S.C. 603 and was made available to the public.

A. Need for the Rule

    Part 205 complies with Section 307 of the Sarbanes-Oxley Act of 
2002 (15 U.S.C. 7245), which requires the Commission to prescribe 
``minimum standards of professional conduct for attorneys appearing and 
practicing before the Commission in any way in the representation of 
issuers. * * *'' The standards must include a rule ``requiring an 
attorney to report evidence of a material violation of securities law 
or breach of fiduciary duty or similar violation by the company or any 
agent thereof'' to the CLO or the CEO of the company (or the equivalent 
thereof); and, if they do not respond appropriately to the evidence, 
requiring the attorney to report the evidence to the audit committee, 
another committee of independent directors, or the full board of 
directors.

B. Significant Issues Raised by Public Comment

    The Commission received no comments in response to the IRFA.

[[Page 6319]]

C. Small Entities Subject to Part 205

    Part 205 would affect issuers and law firms that are small 
entities. Exchange Act Rule 0-10(a) (17 CFR 240.0-10(a)) defines an 
issuer, other than an investment company, to be a ``small business'' or 
``small organization'' if it had total assets of $5 million or less on 
the last day of its most recent fiscal year. As of October 23, 2002, we 
estimated that there were approximately 2,500 issuers, other than 
investment companies, that may be considered small entities. For 
purposes of the Regulatory Flexibility Act, an investment company is a 
small entity if it, together with other investment companies in the 
same group of related investment companies, has net assets of $50 
million or less as of the end of its most recent fiscal year.\146\ We 
estimate that there are 211 small investment companies that would be 
subject to the rule. The revisions would apply to any small entity that 
is subject to Exchange Act reporting requirements.
---------------------------------------------------------------------------

    \146\ 17 CFR 270.0-10.
---------------------------------------------------------------------------

    Part 205 also would affect law firms that are small entities. The 
Small Business Administration has defined small business for purposes 
of ``offices of lawyers'' as those with under $6 million in annual 
revenue.\147\ Because we do not directly regulate law firms appearing 
before the Commission, we do not have data to estimate the number of 
small law firms that practice before the Commission or, of those, how 
many have revenue of less than $6 million. We sought comment on the 
number of small law firms affected by the rules, but received none.
---------------------------------------------------------------------------

    \147\ 13 CFR 121.201.
---------------------------------------------------------------------------

D. Reporting, Recordkeeping and Other Compliance Requirements

    Paragraph 205.3(b) prescribes the duty of an attorney who appears 
or practices before the Commission in the representation of an issuer 
to report evidence of a material violation that has occurred, is 
ongoing, or is about to occur. The attorney is initially directed to 
make this report to the issuer's CLO, or to the issuer's CLO and CEO.
    When presented with a report of a possible material violation, the 
rule obligates the issuer's CLO to conduct a reasonable inquiry to 
determine whether the reported material violation has occurred, is 
occurring or may occur. A CLO who reasonably concludes that there has 
been no material violation must advise the reporting attorney of this 
conclusion. A CLO who concludes that a material violation has occurred, 
is occurring or is about to occur must take reasonable steps to ensure 
that the issuer adopts appropriate remedial measures and/or sanctions, 
including appropriate disclosures. Furthermore, the CLO is required to 
report up-the-ladder within the issuer and to the reporting attorney 
what remedial measures have been adopted.
    A reporting attorney who receives an appropriate response within a 
reasonable time has satisfied all obligations under the rule. In the 
event a reporting attorney does not receive an appropriate response 
within a reasonable time, he or she must report the evidence of a 
material violation to the issuer's audit committee, to another 
committee of independent directors if the issuer has no audit 
committee, or to the full board if the issuer has no such committee. 
Similarly, if the attorney reasonably believes that it would be futile 
to report evidence of a material violation to the CLO and CEO, the 
attorney may report directly to the issuer's audit committee, another 
committee of independent directors, or to the full board.
    Alternatively, pursuant to paragraph 205.3(c), issuers may (but are 
not required to) establish a QLCC, consisting of at least one member of 
the issuer's audit committee and two or more independent members of the 
issuer's board, for the purpose of investigating reports of material 
violations made by attorneys. Such a QLCC would be authorized to 
recommend to the issuer that it adopt appropriate remedial measures to 
prevent ongoing or alleviate past material violations, and empowered to 
notify the Commission of the material violation if the QLCC decides, by 
a majority vote, that the issuer has failed to take any remedial 
measure that the QLCC has directed the issuer to take. The QLCC would 
be required to notify the board of the results of any inquiry. An 
attorney other than a CLO may satisfy entirely his or her reporting 
obligations under the rule by reporting evidence of a material 
violation to a QLCC. Further, a CLO to whom a report of a material 
violation has been made may refer the matter to a QLCC.
    Paragraph 205.3(d) sets forth the specific circumstances under 
which an attorney is authorized to disclose confidential information 
related to his or her appearance and practice before the Commission in 
the representation of an issuer. Pursuant to this provision, an 
attorney may use any contemporaneous records he or she creates to 
defend against charges of attorney misconduct. Paragraph 205.3(d)(2) 
also allows an attorney to reveal confidential information to the 
extent necessary to prevent the commission of a material violation that 
the attorney reasonably believes will result either in perpetration of 
a fraud upon the Commission or in substantial injury to the financial 
or property interests of the issuer or investors. Similarly, the 
attorney may disclose confidential information to rectify an issuer's 
material violations when such actions have been advanced by the 
issuer's use of the attorney's services.
    We expect that the various reporting requirements required by Part 
205 would, at least to a limited extent, increase costs incurred by 
both small issuers and law firms. We believe that many of these reports 
are, however, already being made by those affected by the rule. We are 
unable to estimate the frequency with which reports would have to be 
prepared by small entities. The time required for the actual 
preparation of a report would vary, but should not be extensive. Small 
issuers and law firms may bolster, and in some instances institute, 
internal procedures to ensure compliance--although the rule does not 
dictate how these procedures should be implemented.

E. Agency Action To Minimize Effect on Small Entities

    The Regulatory Flexibility Act directs the Commission to consider 
significant alternatives that would accomplish the stated objective, 
while minimizing any significant adverse impact on small entities. In 
connection with the rule, we considered the following alternatives: (a) 
The establishment of differing compliance or reporting requirements 
that take into account the resources available to small entities; (b) 
the clarification, consolidation, or simplification of the reporting 
requirements for small entities; (c) an exemption from coverage of the 
requirements, or any part thereof, for small entities; and (d) the use 
of performance rather than design standards. As discussed above, the 
Sarbanes-Oxley Act directs the Commission to implement rules requiring 
up-the-ladder reporting. The Act does not contain any exemption or 
other limitation for small entities. Small business issuers may have 
some difficulty staffing a QLCC, as we presume that they may have fewer 
independent directors. We note that issuers are not required to have a 
QLCC under the rule.
    The rule uses some performance standards and some design standards. 
While the rule establishes a framework for reporting evidence of 
material violations up-the-ladder, it does not set specific standards 
for how to comply with the rule's requirements. For the

[[Page 6320]]

most part, rather than requiring reports to contain specific, detailed 
disclosures, the rule prescribes general requirements for reporting. 
This should give small entities flexibility in complying with the rule.
    By permitting issuers to establish QLCCs as an alternative 
mechanism for attorneys to report evidence of misconduct or fraud, the 
rule presents a performance standard (as opposed to a design standard). 
A performance standard is characterized by the provision for 
alternative means of fulfilling the regulatory standard. It has the 
advantage of permitting market participants to choose the method of 
meeting the standard that presents the least cost to them. The 
provision of alternative reporting mechanisms within this rule should 
serve to lower overall costs to issuers attributable to the rule in 
precisely this manner.
    We believe that utilizing different reporting or other compliance 
requirements for small entities would undermine the effective 
functioning of the reporting regime. The rule is designed to restore 
investor confidence in the reliability of the financial statements of 
the companies they invest in--if small entities were not subject to 
such requirements, investors might be less inclined to invest in their 
securities. Further, we see no valid justification for imposing 
different standards of conduct upon small law firms than would apply to 
others who choose to appear and practice before the Commission. We also 
believe that the reporting requirements will be at least as well 
understood by small entities as would be any alternate formulation we 
might formulate to apply to them. Therefore, it does not seem necessary 
or appropriate to develop separate requirements for small entities.

VII. Statutory Authority

    The Commission is adding a new Part 205 to Title 17, Chapter II, of 
the Code of Federal Regulations under the authority in Sections 3, 307, 
and 404 of the Sarbanes-Oxley Act of 2002,\148\ Section 19 of the 
Securities Act of 1933,\149\ Sections 3(b), 4C, 13, and 23 of the 
Securities Exchange Act of 1934,\150\ Sections 38 and 39 of the 
Investment Company Act of 1940,\151\ and Section 211 of the Investment 
Advisers Act of 1940.\152\
---------------------------------------------------------------------------

    \148\ 15 U.S.C. 7202, 7245, 7262.
    \149\ 15 U.S.C. 77s.
    \150\ 15 U.S.C. 78c(b), 78d-3, 78m, 78w.
    \151\ 15 U.S.C. 80a-37, 80a-38.
    \152\ 15 U.S.C. 80b-11.
---------------------------------------------------------------------------

Text of Rule

List of Subjects in 17 CFR Part 205

    Standards of conduct for attorneys.

    For the reasons set out in the preamble, the Commission amends 
Title 17, Chapter II, of the Code of Federal Regulations by adding Part 
205 to read as follows:

PART 205--STANDARDS OF PROFESSIONAL CONDUCT FOR ATTORNEYS APPEARING 
AND PRACTICING BEFORE THE COMMISSION IN THE REPRESENTATION OF AN 
ISSUER

Sec.
205.1 Purpose and scope.
205.2 Definitions.
205.3 Issuer as client.
205.4 Responsibilities of supervisory attorneys.
205.5 Responsibilities of a subordinate attorney.
205.6 Sanctions and discipline.
205.7 No private right of action.

    Authority: 15 U.S.C. 77s, 78d-3, 78w, 80a-37, 80a-38, 80b-11, 
7202, 7245, and 7262.


Sec.  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. 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. 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.


Sec.  205.2  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 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.
    (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 Sec.  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, 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.
    (c) Attorney means any person who is admitted, licensed, or 
otherwise qualified to practice law in any jurisdiction, domestic or 
foreign, or who

[[Page 6321]]

holds himself or herself out as admitted, licensed, or otherwise 
qualified to practice law.
    (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.
    (f) Foreign government issuer means a foreign issuer as defined in 
17 CFR 230.405 eligible to register securities on Schedule B of the 
Securities Act of 1933 (15 U.S.C. 77a et seq., Schedule B).
    (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.
    (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.
    (j) Non-appearing foreign attorney means an attorney:
    (1) Who is admitted to practice law in a jurisdiction outside the 
United States;
    (2) Who does not hold himself or herself out as practicing, and 
does not give legal advice regarding, United States federal or state 
securities or other laws (except as provided in paragraph (j)(3)(ii) of 
this section); and
    (3) Who:
    (i) Conducts activities that would constitute appearing and 
practicing before the Commission only incidentally to, and in the 
ordinary course of, the practice of law in a jurisdiction outside the 
United States; or
    (ii) Is appearing and practicing before the Commission only in 
consultation with counsel, other than a non-appearing foreign attorney, 
admitted or licensed to practice in a state or other United States 
jurisdiction.
    (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 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 Sec.  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 Sec.  
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
    (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.
    (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.
    (n) Report means to make known to directly, either in person, by 
telephone, by e-mail, electronically, or in writing.


Sec.  205.3  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.
    (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.
    (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

[[Page 6322]]

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.
    (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 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.
    (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 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 such evidence of a material violation, and the 
chief legal officer (or the equivalent thereof) provides reasonable and 
timely reports on the progress and outcome of such proceeding 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.
    (7) An attorney shall not have any obligation to report evidence of 
a material violation under this paragraph (b) if such attorney was 
retained or directed by a qualified legal compliance committee:
    (i) To investigate such evidence of a material violation; or
    (ii) To assert, consistent with his or her professional 
obligations, 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 
such evidence of a material violation.
    (8) An attorney who receives what he or she reasonably believes is 
an appropriate and timely response to a report he or she has made 
pursuant to paragraph (b)(1), (b)(3), or (b)(4) of this section need do 
nothing more under this section with respect to his or her report.
    (9) An attorney who does not reasonably believe that the issuer has 
made an appropriate response within a reasonable time to the report or 
reports made pursuant to paragraph (b)(1), (b)(3), or (b)(4) of this 
section shall explain his or her reasons therefor to the chief legal 
officer (or the equivalent thereof), the chief executive officer (or 
the equivalent thereof), and directors to whom the attorney reported 
the evidence of a material violation pursuant to paragraph (b)(1), 
(b)(3), or (b)(4) of this section.
    (10) An attorney formerly employed or retained by an issuer who has 
reported evidence of a material violation under this part and 
reasonably believes that he or she has been discharged for so doing may 
notify the issuer's board of directors or any committee thereof that he 
or she believes that he or she has been discharged for reporting 
evidence of a material violation under this section.
    (c) Alternative reporting procedures for attorneys retained or 
employed by an issuer that has established a qualified legal compliance 
committee. (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 may, as an 
alternative to the reporting requirements of paragraph (b) of this 
section, report such evidence to a qualified legal compliance 
committee, if the issuer has previously formed such a committee. An 
attorney who reports evidence of a material violation to such a 
qualified legal compliance committee has satisfied his or her 
obligation to report such evidence and is not required to assess the 
issuer's response to the reported evidence of a material violation.
    (2) A chief legal officer (or the equivalent thereof) may refer a 
report of evidence of a material violation to a previously established 
qualified legal compliance committee in lieu of causing an inquiry to 
be conducted under paragraph (b)(2) of this section. The chief legal 
officer (or the equivalent thereof) shall inform the reporting attorney 
that the report has been referred to a qualified legal compliance 
committee. Thereafter, pursuant to the requirements under Sec.  
205.2(k), the qualified legal compliance committee shall be responsible 
for responding to the evidence of a material violation reported to it 
under this paragraph (c).

[[Page 6323]]

    (d) Issuer confidences. (1) Any report under this section (or the 
contemporaneous record thereof) or any response thereto (or the 
contemporaneous record thereof) may be used by an attorney in 
connection with any investigation, proceeding, or litigation in which 
the attorney's compliance with this part is in issue.
    (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:
    (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 investors;
    (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.


Sec.  205.4  Responsibilities of supervisory attorneys.

    (a) An attorney supervising or directing another attorney who is 
appearing and practicing before the Commission in the representation of 
an issuer is a supervisory attorney. An issuer's chief legal officer 
(or the equivalent thereof) is a supervisory attorney under this 
section.
    (b) A supervisory attorney shall make reasonable efforts to ensure 
that a subordinate attorney, as defined in Sec.  205.5(a), that he or 
she supervises or directs conforms to this part. To the extent a 
subordinate attorney appears and practices before the Commission in the 
representation of an issuer, that subordinate attorney's supervisory 
attorneys also appear and practice before the Commission.
    (c) A supervisory attorney is responsible for complying with the 
reporting requirements in Sec.  205.3 when a subordinate attorney has 
reported to the supervisory attorney evidence of a material violation.
    (d) A supervisory attorney who has received a report of evidence of 
a material violation from a subordinate attorney under Sec.  205.3 may 
report such evidence to the issuer's qualified legal compliance 
committee if the issuer has duly formed such a committee.


Sec.  205.5  Responsibilities of a subordinate attorney.

    (a) An attorney who appears and practices before the Commission in 
the representation of an issuer on a matter under the supervision or 
direction of another attorney (other than under the direct supervision 
or direction of the issuer's chief legal officer (or the equivalent 
thereof)) is a subordinate attorney.
    (b) A subordinate attorney shall comply with this part 
notwithstanding that the subordinate attorney acted at the direction of 
or under the supervision of another person.
    (c) A subordinate attorney complies with Sec.  205.3 if the 
subordinate attorney reports to his or her supervising attorney under 
Sec.  205.3(b) evidence of a material violation of which the 
subordinate attorney has become aware in appearing and practicing 
before the Commission.
    (d) A subordinate attorney may take the steps permitted or required 
by Sec.  205.3(b) or (c) if the subordinate attorney reasonably 
believes that a supervisory attorney to whom he or she has reported 
evidence of a material violation under Sec.  205.3(b) has failed to 
comply with Sec.  205.3.


Sec.  205.6  Sanctions and discipline.

    (a) A violation of this part by any attorney appearing and 
practicing before the Commission in the representation of an issuer 
shall subject such attorney to the civil penalties and remedies for a 
violation of the federal securities laws available to the Commission in 
an action brought by the Commission thereunder.
    (b) An attorney appearing and practicing before the Commission who 
violates any provision of this part is subject to the disciplinary 
authority of the Commission, regardless of whether the attorney may 
also be subject to discipline for the same conduct in a jurisdiction 
where the attorney is admitted or practices. An administrative 
disciplinary proceeding initiated by the Commission for violation of 
this part may result in an attorney being censured, or being 
temporarily or permanently denied the privilege of appearing or 
practicing before the Commission.
    (c) An attorney who complies in good faith with the provisions of 
this part shall not be subject to discipline or otherwise liable under 
inconsistent standards imposed by any state or other United States 
jurisdiction where the attorney is admitted or practices.
    (d) An attorney practicing outside the United States shall not be 
required to comply with the requirements of this part to the extent 
that such compliance is prohibited by applicable foreign law.


Sec.  205.7  No private right of action.

    (a) Nothing in this part is intended to, or does, create a private 
right of action against any attorney, law firm, or issuer based upon 
compliance or noncompliance with its provisions.
    (b) Authority to enforce compliance with this part is vested 
exclusively in the Commission.

    By the Commission.

    Dated: January 29, 2003.

Jill M. Peterson,
Assistant Secretary.
[FR Doc. 03-2480 Filed 2-5-03; 8:45 am]
BILLING CODE 8010-01-P