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

• Author: Ferrara, Ralph C.
• Position: 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...