While the duty of loyalty to corporations and the ethical standards of corporate counsel are not new ideas, a periodic reminder about what those standards are is welcome. Corporate counsel owes a duty of loyalty to the corporation, not its officers. Counsel also provides guidance and advice to employees of the organization about how to carry out their fiduciary duties. When counsel has evidence of a misdeed involving an officer or employee that might also have been a client, there are conflicting duties to the corporation and the officer or employee. This is a delicate relationship built on trust and the expectation that generally, communication between corporate employees and corporate attorneys will not be subject to disclosure.
Rule 1.13of the ABA Model Rules of Professional Conduct governs the disclosure standards for corporate counsel and has been adopted by every jurisdiction in some form. (Note that some states, like Missouri, have not adopted the updated version o f Rule 1.13, so reporting outside of the organization is not permissible.) The key elements of Rule 1.13 are the degree of knowledge that triggers attorney reporting of corporate misdeeds and the amount of discretion corporate counsel has in addressing this perceived knowledge. The degree of knowledge that triggers the reporting requirement occurs when the attorney “knows” of ongoing wrongful acts or future wrongful acts. Further, the trigger is only activated when those acts are a violation of law that “reasonably might be imputed to the organization” or that will likely “result in substantial injury to the organization.” Once the attorney learns of such conduct, the attorney is required “to proceed as is reasonably necessary in the best interest of the organization” and accordingly has the discretion to determine how to report: report up within the organization or report outside of the organization.
Reporting outside of the organization is only appropriate when reporting up the chain of command within the organization has been exhausted, no action has been taken by the officers, and when such a violation of law is reasonably certain to result in substantial injury to the organization. Only then may the attorney reveal information to the extent reasonably necessary to prevent substantial injury to the organization. Ultimately, the Model Rules require reporting, but the attorney remains empowered to exercise discretion in determining when to report violations by corporate employees and officers. Giving corporate counsel such discretion is necessary in order to maintain the relationship between corporate counsel and employees of the corporation and avoid discouraging counsel to take action when necessary. The ABA commentators were concerned that weakening the relationship of trust and openness between corporate counsel and corporate employees would lead to less communication and increased risk of corporate employees unintentionally engaging in wrongful behavior.
In addition to the Model Rules, the SEC implemented Section 307 of the Sarbanes-Oxley Act, which sets forth “standards of professional conduct for attorneys appearing and practicing before the [SEC] in any way in the representation of issuers.” The SEC broadly defines “appearing and practicing” to include attorneys that represent issuers and those that do not. Attorneys that have any communications with the SEC or participate in preparing any document that the attorney should anticipate will be submitted to the SEC falls under the scope of “appearing and practicing.” Also, attorneys that have no contact with the SEC may be included under the rule if they advise any party or organization that it is not required to make disclosures or submissions to the SEC or if attorneys represent private companies that do business with public companies and it benefits the public company in any way. This means that in some cases, attorneys may be obligated to report up within an organization that is not their client. For example, the SEC cites a case where a privately held company acts as an investment adviser to a public mutual fund. If the attorney for the private company assists in preparing the mutual fund’s SEC filings, the private company’s attorney will be obligated to report up any misconduct within the public mutual fund’s organization.
Under Section 307, when an attorney becomes aware of evidence of a material violation by the issuer or by any officer, director, employee, or agent of the issuer, the attorney must report up to the chief legal counsel or chief executive officer of the organization. (The SEC defines “material violations” as any material violation of federal securities laws, any material breach of fiduciary duty recognized by common law, or any “similar material violation”.) If the attorney does not receive an appropriate response, the attorney is required to report to the audit committee or the full board.
If the material violation is ongoing or regarding an SEC filing and there is still no appropriate response from the CEO or chief legal counsel, the attorney must notify the SEC that the attorney is disaffirming any “tainted” SEC filing that the attorney participated in preparing. Further, if the participating attorney is outside counsel, the attorney must notify the SEC of withdrawal from representation of the issuer based on “professional considerations,” which the SEC states will “virtually ensur[e]” an immediate SEC inquiry into the matter. Noisy withdrawal and disaffirmation is permitted under Section 307 for material violations that have occurred in the past; however, the SEC has taken the position that failure to disclose past violations may itself be an ongoing violation.
Section 307 also provides for an alternative reporting channel if the issuer’s board of directors establishes a “qualified legal compliance committee.” The QCLC would be comprised of at least one member of the issuer’s audit committee and two or more independent board members. The primary purpose of a QCLC would be to handle attorney reports of misconduct and advise the issuer on how to implement an appropriate response to a report of a material violation.
Further, Section 307 expressly states that it preempts any conflicting state laws unless those state laws impose more stringent requirements. Section 307 is inconsistent with most states’ rules of professional conduct, which are modeled after the ABA Model Rules, to the extent in which they require or permit attorneys to report conduct outside the organization.
When Section 307 was proposed, there was significant controversy. The rule came in the wake of Enron and WorldCom when there was public outcry for more regulation of corporate counsels. Several commentators argued that the rule would create a trap for the unwary because they can apply to attorneys that do not represent public companies. The rule has been criticized because it effectively requires attorneys to “tip” the SEC about misconduct by public companies when state attorney ethics rules would either prohibit disclosure or not require disclosure. Perhaps the biggest concern is that Section 307 would erode the relationship between corporate counsel and corporate employees, which is built on trust and openness, and actually cause more harm than good.
The ethical rules that apply to corporate counsel require attorneys to strike a delicate balance between the attorneys’ duty of loyalty to the corporation and the attorneys’ required conduct regulated by the state and the SEC.