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Life on top of the ladder: boards of directors, and not just attorneys, need to prepare for the SEC's new reporting regime. (Legal Brief).

UNDER THE NEW standards of professional conduct ,a corporate attorney who discovers "evidence of a material violation" must report that evidence to the company's chief legal officer. If the company does not respond appropriately to the report, the attorney is obligated to report the evidence "up the ladder" to the board of directors.

The standards have been adopted as a final rule to become effective on August 4, but the process is not yet complete. The SEC is continuing to consider whether the standards should require an attorney to withdraw from an engagement and notify the agency if a corporate client fails to rectify an ongoing violation that has been reported to the board. Alternatively, the SEC may require the company itself to notify the agency when counsel resigns.

Although directed at attorneys, the rule will also have a profound impact on boards of directors. It is intentionally structured to encourage greater board involvement in the investigation of potential violations, and it effectively requires board participation in decisions to litigate material matters. It also provides boards with the option of establishing a "qualified legal compliance committee" (QLCC) to take direct responsibility for the investigation and disposition of reported matters. 'Whether to establish a QLCC is a fundamental decision that every board will need to make in the coming months.

The Reporting Process. Under the basic reporting process established by the rule, an attorney who discovers evidence of a material violation must report that evidence to the chief legal officer. The chief legal officer is then obligated to investigate the matter and take steps to cause the company to make "an appropriate response" to the report. An appropriate response is one that enables the reporting attorney to reasonably believe that (1) no violation exists, (2) the company has taken appropriate remedial measures, or (3) on the advice of another attorney who reviewed the matter, the company intends to assert "a colorable defense" in any investigation or proceeding based on the reported evidence.

Reliance on a colorable defense is an appropriate response under the rule only if the full board or a committee of independent directors consents to the second attorney's review of the evidence. This is intended to ensure board involvement in any decision to litigate what may be a material violation.

The QLCC Concept. A company has the option to establish a QLCC to receive and investigate reports of a potential violation. Where a QLCC is in place, any attorney may report directly to the QLCC rather than go through the chief legal officer. An attorney who reports directly to a QLCC has no continuing obligation to assess whether the company makes an appropriate response.

A QLCC must consist of independent directors (including at least one audit committee member) and have both the authority and the responsibility to (1) conduct internal investigations, (2) retain outside counsel and other experts, (3) recommend appropriate responses, and (4) take other appropriate action, including notifying the SEC if the company fails to implement an appropriate response recommended by the QLCC. An audit committee may also serve as a QLCC.

Although forming a QLCC is optional, the SEC clearly favors the idea as a way of encouraging early board involvement in the review of potential violations. A board should not establish a QLCC, however, simply because the SEC likes the idea. For some companies, service on a QLCC could effectively be a full-time job, especially for members already serving on an audit committee. In addition, while a QLCC would not dictate how a company responds to a reported violation, it must have the authority to notify the SEC if the company fails to implement its recommendations. This is obviously not a delegation to be made lightly.

On the other hand, it is likely that a QLCC would make attorneys less reluctant to bring potentially troublesome matters involving senior management to the attention of the board. As a practical matter, a company's general counsel, or its outside counsel, cannot go over a CEO's head to the board of directors without impairing the working relationship with the CEO. For that reason, they may hesitate to do so unless an issue is black and white. The dynamics of reporting to the board would be fundamentally changed, however, where a company has formed a QLCC for the express purpose of reviewing matters that might potentially violate the law. This alone would be a substantial benefit.

Ralph Ferrara is a former SEC general counsel, He is now a partner of Debevoise & Plimpton and head of its Washington, D.C., office. Phillip Parker, who served on the staff of the SEC for 20 years, is counsel in the law firm's Washington, D.C., office.
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Author:Ferrara, Ralph C.; Parker, Phillip D.
Publication:Directors & Boards
Geographic Code:1USA
Date:Mar 22, 2003
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