The world according to Sarbanes-Oxley

Not since the Great Depression has there been such an avalanche of new securities laws and regulations pouring out of Congress and the SEC. Prompted by scandals, bankruptcies and criminal charges, Congress last year passed the sweeping Public Company Accounting Reform and Investor Protection Act, better known as the Sarbanes-Oxley Act, or SOX. The law directs the Securities and Exchange Commission to create regulations, including those pertaining to the conduct of corporate lawyers, to "deter instances of attorney and issuer misconduct."

The legislation was driven by sentiment that corporate advisers, notably lawyers, who are privy to corporate decisions should be held accountable when misconduct occurs. Although CEOs and CFOs have borne the brunt of media and prosecutorial scrutiny, lawyers have increasingly come under fire as well.

In this package of stories, The Deal examines how the new legislation may affect the corporate bar, private companies, venture capitalists as well as foreign issuers. We hear from Sen. John Edwards, D-N.C., a presidential candidate (and former trial lawyer) who sponsored stronger regulation of lawyers whose decisions affect public markets. And our Safe harbor and Judgment call columns focuses on Sarbanes-Oxley as well.

The new rule proposals are significant, affecting in-house counsel or law firms that work for what the SEC estimates are as many as 18,200 companies or issuers.

Enacting the proposed rules has hardly been controversy-free. Earlier this year, the SEC announced that it was extending the comment period on one rule, known as "noisy withdrawal." That extension was spun as a victory for the corporate bar in its effort to block the proposal. It may prove to be a short-lived one.

M. Peter Moser, the head of the American Bar Association's task force on the matter, says he and a colleague met with all five SEC commissioners and its general counsel in a single day. The ABA, the largest professional legal organization in the U.S., made it clear that it strongly opposed the provision requiring lawyers to withdraw from representing a corporate client, then quickly notify the SEC that they were resigning for professional reasons.

"We said virtually every lawyer who commented indicated that they thought noisy withdrawal was counterproductive and there ought to be more time for people to comment on it and have the SEC examine alternatives," Moser says.

Moser won his reprieve. But the public still has two more months to weigh in on the proposal and consider the SEC's alternative that would require companies to publicly notify investors when lawyers withdraw for professional reasons, a subtle change. "Our hope is that noisy withdrawal is eliminated completely," Mark S. Inzetta, an assistant general counsel for Wendy's International Inc., said during a recent ABA teleconference. So far, he admits, "The bar has done a Houdini escape act." What are some of the proposed rules? Under the "up-the-ladder" rule, if a lawyer for a company finds evidence of a material violation of securities laws he or she must disclose it to the corporation's chief legal officer or to that officer and the CEO (or qualified legal compliance committee). The chief legal officer must conduct an investigation. If the attorney fails to get an appropriate response, he or she should proceed to the board.

The up-the-ladder reporting requirements, specifically outlined in SOX, haven't generated anywhere near the opposition that noisy withdrawal has. Under that provision, if the board doesn't respond appropriately, then the outside law firm is supposed to withdraw from representation and notify the SEC within one business day. An in-house counsel wouldn't need to resign but would be required to tell the SEC within one business day that he or she was disavowing any filings relating to the alleged wrongdoing.

"Everyone knows this is a code," says Guy Lander, chair of the New York State Bar Association section on business law and a partner at Davies Ward Phillips & Vineberg LLP. "The SEC would be on your doorstep the next day."

The ABA task force has not yet issued its formal statement on the latest alternative, Moser says. But even having the corporation disclose its law firm's resignation in an 8-K filing is problematic, he says. What if the firm is wrong about misconduct? "An 8-K filing is public," Moser says. "It isn't going to help the value of the stock. People who are buying and selling the stock are acting on hunches."

While still in flux, SOX and the new SEC rules are the natural outgrowth of corporate scandals at companies such as Enron Corp., Arthur Andersen, WorldCom Inc.

Would the proposed rules for corporate lawyers have prevented or minimized the kind of wrongdoing alleged in shareholder cases against Enron and its outside counsel, Vinson & Elkins LLP? The Houston law firm, one of several defendants, failed to get itself dismissed from the class action now pending in Houston federal court. Shareholder-plaintiffs, who seek $25 billion in damages, allege that the firm participated in Enron's fraud by drafting the energy trader's shareholder reports, SEC filings, press releases and by structuring certain transactions.

In refusing to dismiss Vinson & Elkins from the case, U.S. District Court Judge Melinda Harmon concluded that: "In light of its alleged voluntary, essential, material and deep involvement as a primary violator in the ongoing Ponzi scheme, Vinson & Elkins was not merely a drafter, but essentially a co-author of the documents it created for public consumption concealing its own and other participants' actions."

The firm, which is appealing the ruling, argued in court papers that it had "a minimal role in the 68 Enron disclosures that the complaint alleges are fraudulent."

Minimal or not, the proposed lawyer rules would, if they had been in place at the time, have required Vinson & Elkins to resign from representing Enron as soon as it got wind of fraud. Still, the main complaints about noisy withdrawal is that the SEC went beyond congressional intent and that the rule would damage the attorney-client relationship. The ABA, in its comment letter to the SEC, said that the provision would "risk destroying the trust and confidence many issuers have up to now placed in their legal counsel, creating divided loyalties and driving a wedge into the attorney-client relationship."

Even companies on the client side asked that the SEC reconsider the controversial proposal. The top counsel at International Paper Co., James P. Melican, in a letter to the SEC, wrote, "The most significant drawback of the proposed rule: the very real possibility that the requirement of a noisy withdrawal by outside counsel will have a double-barreled chilling effect upon the willingness of (1) inside counsel to contact outside experts at precisely the time when outside advice may be most important, and (2) business leaders to engage their legal advisers in exactly the type of open attorney-client communications necessary to comply with the spirit of [SOX]."

And in its comment letter to the SEC, New York law firm Sullivan & Cromwell argued: "By effectively requiring attorneys to police and pass judgment on their clients, the basic attorney- client dynamic is altered fundamentally — instead of viewing attorneys as confidential advisers, clients may begin to view their attorneys as also being agents of the Commission."

The legal profession brought so much pressure to bear that the SEC offered the alternative of having a firm withdraw in writing, then make the company and its board disclose that within two business days — taking some of the onus from the law firms.

Richard W. Painter, a visiting law professor at the University of Michigan at Ann Arbor who opposes lawyers regulating themselves, presented the alternative now out for comment. "I would be willing to live with an arrangement where the lawyer has to quit and the client has to disclose that in an 8-K filing," Painter says. "You're not requiring [the lawyers] to disclose information to the government. There's just the requirement to get out of there. It seems to me that is what any halfway intelligent lawyer is going to do anyway."

The alternative also gives the SEC an avenue to retreat without caving in entirely to the interests of the organized bar. "It would be a huge mistake for the SEC to retreat entirely," Painter says.

That sentiment was echoed by Barbara Roper of the Consumer Federation of America. If the SEC adopted the alternative proposal, "It's not an area where they would be open for criticism," Roper says. "Nonetheless, it may be symptomatic of a pattern of backing away from reform."