This article is written to provide guidance to issuers under the Sarbanes-Oxley Act of 2002 (Act). It will also provide guidance to those companies, brokerage houses, banks, and limited partnerships which wish to be guided by the standards of that Act.

Section 307 of the Act is found at 15 U.S.C. § 7245. The regulations, issued by the SEC are found at 17 C.F.R. § 205 et seq.

Whistleblowers under the new rules are encouraged to come forward and report wrongdoing on behalf of a covered issuer (company). Their allegations will normally be made to a member of the company's legal staff. Under those circumstances, a covered attorney has defined duties. If that attorney is a subordinate attorney then his duty is to report the alleged wrongdoing to the chief legal officer (CLO) or the chief executive officer (CEO) of the issuer. The CLO or the CEO must report back to the reporting attorney either that no violation has occurred, is ongoing or is about to occur, or that all reasonable steps have been taken to correct the allegations in question. That is known as an "appropriate response" and is covered by 17 C.F.R. § 205.2(b). In most cases, however, before an appropriate response can be formulated the CLO, a member of his staff or a representative of the board of directors, must conduct an appropriate and reasonable investigation. That is because the attorney reporting the allegation is allowed to use his judgment concerning whether or not the response is appropriate, as long as that judgment is reasonable under the circumstances. If the CLO and the reporting attorney believe that the response is appropriate, and is rendered within a reasonable period of time, there is no further duty under the Act.

The first question to be considered is what is an appropriate investigation seeking? The investigation is generally trying to determine if there is credible evidence of a material violation of securities law, breach of fiduciary duty or similar violation by the issuer, or an agent of the issuer, which is likely to result in substantial injury to the financial interest or property of the issuer or to investors. [Please see "Your Company's Basic Obligations Under § 307 of the Sarbanes-Oxley Act of 2002" which is attached as Appendix A.] In addition, the investigation is seeking any type of financial or material fraud.

Before an investigation begins there are several factors that need to be considered or accomplished as follows:

What is the proposed scope of the investigation? This depends upon the weight and nature of the evidence reported, who is involved in the allegations and the seriousness of the charge itself. For example, if a high ranking officer is involved, and the allegations involve intentional wrongful corporate conduct or repeated negligent corporate conduct those charges are serious. If the charges are likely to affect the financial condition of the company or deal with fraud or breach of fiduciary duty (especially by an important company employee or agent) the charges are serious. If the charges involve a substantial amount of money or a substantial risk to the company, the charges are serious. When considering whether a risk that has yet to occur, the CLO and/or investigator should be concerned with its potential consequences and impact on the company should it occur.Gathering documents. As part of the initial risk assessment those documents and E-mails that are readily accessible to members of the company should be obtained. They will give the evaluating attorney a better understanding of the nature and scope of the issues with which he is confronted. Consider spoliation. The person performing the initial evaluation should consider whether or not to send out a memorandum advising certain people not to destroy documents or potential evidence that pertains to the issue.Who is in the best position to conduct the investigation? Whether or not the investigation should be conducted by in-house counsel, outside general counsel, or independent counsel is an important strategy decision. If the investigator is an attorney with an interest in the outcome, has a conflict of interests, may be a witness, or may be unduly influenced by the issuer, than the report will not be considered independent. For better or for worse, in-house lawyers and outside general counsel are considered to be under the influence of the issuer. (See comments at 17 C.F.R. § 205.2(b)). These lawyers know the issuer very well, and can be of great help, but they are at a disadvantage when it comes to perceived objectiveness and neutrality.

Once the initial strategy considerations have been determined and the investigation begins, the following items should be considered by the investigating attorney:

All privileges must be protected to the extent allowed by law. They can be waived later but if they are not initially protected there is nothing to waive. If material is to be shared with the SEC, they should feel they have received something of value in trade for their consideration not to prosecute. This is why the privilege must be protected.The directors' and officers' policy should be examined. Certain investigations may be covered but it depends upon whether or not the issuer chooses to report the claim, and the exact wording of the policy.The identity of the records keeper and the source of evidence need to be defined. The most important people should generally be interviewed first.The investigator should determine what to advise potential witnesses about whom he represents and what the witness' rights and obligations are.The investigating attorney should determine what written records to create. Should he take written or recorded statements? How extensive should his notes be? What communications should be sent to the issuer's counsel? It must be recalled that information discovered, and created, during an investigation may be discoverable or may be requested by the SEC as a sign of good faith if the commission becomes involved.It should be determined what experts, if any, should be retained. Investigating counsel may find that he cannot understand what has happened, either financially or technically without the aid of an expert. This may be a safety expert, an engineer, a CPA, a professional private investigator, or a fellow attorney skilled in a different area of law. For example, the issue may involve employment. If employment discrimination is alleged a labor and employment attorney should be part of the team.The investigating attorney should determine, as soon as possible, whether or not there is any potential criminal liability on behalf of any of the directors, officers or employees of the corporation. If there is then an attorney familiar with criminal law needs to become part of the team and certain additional privileges, such as Fifth Amendment privileges, should be considered.The investigating attorney needs to determine whether or not there is any third party who may be wholly or partially responsible for the wrongdoing (assuming one has occurred) and whether or not that third party may be subject to contribution or indemnification. This will also involve the additional decision of when to notify that third party. This is an important decision because the issuer may not want to notify a potential adversary who may be inclined to launch a preemptive strike. It is a distinct disadvantage to be sued in an unfavorable jurisdiction, at an inappropriate time, when you should be the plaintiff.Legal research should be performed and an analysis of the allegation made. Counsel should assess the information that has been gathered to determine how it is affected by the law including the Securities Act of 1933 and the Exchange Act of 1934.A determination should be made who to report to within the issuer's organization, the nature of the report and the detail of the report. Should the report be oral or in writing? A joint defense agreement should be considered.The investigating attorney, along with in-house counsel, should formulate an appropriate response to report back to the reporting attorney or the whistleblower. This is an important part of the process. Essentially it involves negotiations. The design of these negotiations and explanations is to conclude the issue. On the other hand if the situation is more serious than expected, then the appropriate response may need to include appropriate remedial action along with restitution.Counsel and the issuer need to determine whether to make a voluntary disclosure to the SEC. The Act encourages this disclosure. The SEC would like to have the entire investigation disclosed turned over to them so they can determine whether any violation of law has occurred. This can involve substantial questions of exposure to officers and directors along with possible waivers of privilege. A confidentiality agreement needs to be considered.Under certain circumstances the financial information submitted to the SEC in quarterly and annual reports may need to be restated. Whether or not this should occur can have serious ramifications and needs to be analyzed with legal staff, appropriate officers and directors along with the issuer's accountants. 

If the SEC becomes involved, a question will arise concerning what investigation factors they will use to determine the fairness and neutrality of the investigation. The following will be considered in all likelihood:

What is the relationship between the seriousness of the allegations and the depth of the investigation? The greater and more credible the evidence, and the more serious the charge, the deeper the scope of the investigation should be. As the investigation proceeds the evidence may be found to be less credible or less serious. If this occurs the scope may change. On the other hand, the scope may increase if the evidence begins to accumulate and become more credible and serious. What is credible evidence is a matter or judgment, but generally it is defined to be the type of evidence that would be likely to influence a reasonable person. For this reason, lawyers familiar with investigations, privilege, rules of evidence and jury trials can be helpful. There are other reasons why special outside counsel should be considered. These reasons include such things as protecting coverage and possible conflicts of interest depending upon who is identified as the client. It is likely that if allegations are found to be true, and the situation is not controlled appropriately, and the issuer suffers damages as a result, there will be criticism not only of the wrongdoer but also of the attorneys involved in the process. In addition, a conclusion that there is no material violation, which is incorrect, may be interpreted by some as aiding and abetting an offense. What information may the investigating person rely upon? The answer is that he may rely upon "reasonable and appropriate factual representations and legal determinations of persons on whom a reasonable attorney would rely." (See comments at 17 C.F.R. 205.2(b)). Just how this determination is made, and what types of information to seek, is not defined. Common sense dictates that the type of person upon whom a reasonable attorney would rely is a person with personal knowledge of the situation who has the characteristics of a credible witness under the circumstances. That may include the expertise to understand the circumstances. A skilled investigator will look for conflicts in statements made by potential witnesses as well as illogical positions or conclusions including possible bias. These are the same tests that a judge gives to a jury when charging them on the credibility of witnesses. 

Conclusion

The Sarbanes-Oxley Act has created many new duties and obligations for attorneys and companies covered by the Act. In addition, there is likely to be a cascading effect from this Act. States are likely to pass their own versions of the Sarbanes-Oxley Act and thirteen states have already done so. Therefore, a thorough understanding of the new obligations and duties imposed upon lawyers needs to be analyzed and understood before a crisis occurs.  

1For purposes of this article, we assume the attorney is covered by the Act. That means the attorney is providing legal services to the issuer in the context of an attorney-client relationship, and is appearing and practicing before the commission in the representation of an issuer; that the report makes him or her (him or he is meant to include her or she wherever used) aware of threshold credible evidence of a material violation of securities law, breach of fiduciary duty or similar violation. We will also assume that the alleged violation has occurred, is occurring or is likely to occur and is by the company, or an agent of the company, and is likely to result in substantial injury to the financial interests of the company or to investors.

2Fraud "that involves the management or other employees who have a significant role in the issuer's internal controls" must be reported to the auditors and the audit committee. (17 C.F.R. § 302(a)(5)(B).)

Appendix A

Your Company's Basic Obligations Under § 307 of the Sarbanes Oxley Act of 2002

On January 29, 2003 the SEC issued final rules establishing minimum standards of professional conduct for attorneys appearing or practicing before them. The attorney can transfer his or her obligations to the company's chief legal officer, chief executive officer or board of directors. Therefore, it is critical that officers and directors of small companies are aware of the new rules in business.

In short, the new rules require attorneys to report evidence of a material violation of securities law or breach of fiduciary duty or similar violation, by a company, or agent of a company, up the ladder within the company until the attorney receives an adequate response.

The act is designed to protect the company (called issuer), as well as the investing public. Therefore, legal obligations go beyond traditional concepts. Also, there is likely to be a cascading effect from the Act because states are likely to pass little Sarbanes acts and Connecticut is already considering this.

If someone at your company believes that an employee or agent of the company has violated the law, the company must act. This article describes the triggering mechanism that will require action.

WHAT TRIGGERS THE NEED TO ACT?

Your company must act when:

There is credible evidence, which would cause a prudent and competent attorney to reasonably believe that a material violation of:federal or state securities law or breach of fiduciary duty or similar violation of any federal or state law has occurred, is occurring or is likely to occur and is;discovered by an attorney covered by the ACT and this;violation was by an issuer or agent of the issuer; and which violation is;likely to result in substantial injury to the financial interests or property of the issues or to investors.

WHAT DO THESE WORDS MEAN?

Evidence is defined as credible information that would lead a prudent and competent attorney to believe that a material violation has occurred, is occurring, or is about to occur. It does not mean a mere suspicion. It is an objective standard.

Type of Conduct

Intentional and reckless; if the conduct is a conscious plan then it is serious.

Negligence:  

A single instance of highly unreasonable conduct would qualify, orRepeated instances of minor violations. The test has also been phrased in the negative. It is evidence such that "it would be unreasonable, under the circumstances, for a prudent and competent attorney not to conclude that is it reasonably likely that a material violation has occurred, is occurring, or is about to occur.

Material violation is conduct or information which a reasonable investor would want to be informed about before making an investment.

Securities law: refers to violations of federal securities laws including the '33 and '34 Acts as amended by this Act plus any violation of state securities laws.

Breach of fiduciary duty means: breaches of fiduciary duty recognized at common law, including misfeasance, nonfeasance, abdication of duty, abuse of trust, and/or the approval of unlawful transactions.

Similar violation is not defined, but it is likely to encompass a definition that extends beyond a breach of fiduciary duty or a violation of securities law.

Has occurred, is occurring, or is likely to occur: an attorney's reporting obligation is not triggered with respect to future conduct until the attorney can be sure that the officer, employee, director or agent will actually pursue the illegal course of action.

Discovered by an attorney covered by the Act means: an attorney who is acting in any way on behalf, at the behest, or for the benefit of an issuer, whether or not employed or retained by the issuer.

Violation by the company or any agent of the company means: violation by an officer, director, employee or legal agent of the company.

Which is likely to result in substantial injury to the financial interests of the issuer or to investors means: the attorney has become aware of information that an officer, employee or other person associated with the organization is engaged in action, or intends to act or refuses to act, in a way that will violate his legal obligation and such action or lack of action, could reasonably be expected to have a material effect on the issuers financial statements or property, and which could therefore reasonably affect investors.

WHAT HAPPENS IF AN ATTORNEY DOES NOT RECEIVE AN ADEQUATE RESPONSE?

The attorney must report up the ladder within the company. What does that mean?

Definition: Reporting up the ladder means going higher in the company until the attorney receives an appropriate response. If the attorney reports to the CLO, the burden of further reporting switches to the CLO. The attorney may start with a special committee or the board or the quality legal control committee, if one has been and established. If the attorney does not receive an appropriate response, however, he/she may have to report to the SEC. If the attorney transfers his/her obligation then the CIO or board or board committee may need to report to the SEC. The obligation to report could include individual members of the board.

If the attorney has confidential information that may be subject to public disclosure. Generally an attorney and hence your officers and/or directors) may be required to report material violations in the following 3 cases:

To prevent the company from continuing to commit a material violation that is likely to cause substantial injury to the company, or the investing public, and there is not adequate response to the attorney who reported the alleged violation;To prevent the company (in an SEC investigation) from committing or suborning perjury, or concealing material facts, or using a false document; andTo rectify the consequences of a material violation by the company in which the attorney's services were used that caused, or could cause, injury to the company or investors.

THE SOLUTION [RISK MANAGEMENT]

Over the next 5 years, there will accusations at most companies. The accusations themselves can be debilitating. They will cost money, lower moral, affect stock value and be the source of embarrassment for officers, directors and others. It's better to plan ahead rather than try to manage in crisis.

This Act is extensive. There is considerable controversy as to what each term means. There is controversy about the obligations of an attorney or an auditor who is hired to investigate an allegation. This article is not intended to cover all aspects of § 307. However, it is clear, that each issuer [including small companies] should generally do the following:

Institute a comprehensive training program for its legal staff, officers and directors. They should understand the new rules and what is expected of them. They should also understand the new rules of discovery that can affect them especially the rules of electronic discovery;Develop a structured program and system for reporting alleged violation of law. This is critical in the new age of discovery. Also consider a quality legal control committee;Develop a structured system for dealing with and investigating these allegations; andConsider hiring independent counsel to conduct these investigations because they are more likely to be protected by the attorney client privilege, and can help guide the issuer through difficult times.

The world of professional and executive (including in house lawyers) conduct has been changed dramatically. Attorneys, officers and directors now have a duty to the investing public. Other federal and probably state agencies are likely to enact their own special rules of practice. With these different rules come different standards. An additional article will be issued to further explain how to cope with directors and officers potential liability.