Can a North Carolina lawyer for a publicly traded company disclose confidential information to the SEC under SEC Rule 205, even when the state confidentiality rule would not permit it?

Plain-English summary

Section 307 of the Sarbanes-Oxley Act directed the SEC to set minimum standards of professional conduct for lawyers practicing before it, including a duty to "report up" evidence of a material violation of securities law or breach of fiduciary duty within the company. The SEC's resulting Rule 205 also contains a provision permitting, but not requiring, lawyers to "report out" certain confidential information to the SEC without the issuer's consent. The inquiry asks whether those SEC regulations change the duties of a North Carolina lawyer under the state Rules of Professional Conduct.

The opinion concludes that a North Carolina lawyer faces a potential conflict between Rule 205 and the state rule. Under North Carolina Rule 1.13(c) and Rule 1.6, after reporting misconduct to the organization's highest authority, a lawyer may reveal confidential information outside the organization only to the extent Rule 1.6 permits (for example, to prevent a client's crime under Rule 1.6(b)(2), or to prevent, mitigate, or rectify a client fraud in which the lawyer's services were used under Rule 1.6(b)(4)). In the rare case where the conduct a lawyer wants to disclose under Rule 205 is not a crime and the lawyer's services were not used, the state rule would not permit the disclosure.

The opinion resolves the conflict on preemption grounds. A validly promulgated federal regulation carries the force of federal law and can preempt state law (Fidelity Federal Savings & Loan Ass'n v. de la Cuesta). The opinion finds the SEC's intent to preempt conflicting state ethics rules unambiguous, and reasons that the more restrictive state rule would obstruct the flexibility Rule 205 provides, so a reviewing court would likely hold Rule 205 preempts the state rule if it was validly promulgated. Whether Rule 205's "reporting out" provision was validly promulgated (an issue the opinion frames under Chevron) is beyond the capacity of an ethics opinion to decide.

The opinion therefore concludes that unless and until the Fourth Circuit or the U.S. Supreme Court holds Rule 205 was not validly promulgated, it is presumed valid, and a North Carolina lawyer may disclose confidential information as permitted by Rule 205 without violating the North Carolina Rules, even where the state rule would not otherwise permit the disclosure.

In practice

Under the North Carolina rules as they stood at the time of the opinion, the analysis turns on federal preemption. The opinion holds that a lawyer practicing before the SEC may rely on SEC Rule 205's permissive "reporting out" authority without state discipline, on the presumption that Rule 205 is validly promulgated.

Per the opinion, the only situation where the state rule and Rule 205 actually diverge is the narrow one in which the conduct to be disclosed is neither a crime nor a fraud in which the lawyer's services were used; outside that narrow band, the state confidentiality rule already permits the disclosure Rule 205 allows.

Common questions

Q: Can a North Carolina lawyer report a public company's misconduct to the SEC under Rule 205?

A: Yes, to the extent Rule 205 permits. The opinion concludes a lawyer practicing before the SEC may report out confidential information as Rule 205 allows without violating the North Carolina Rules.

Q: What about the state confidentiality rule that would not permit that disclosure?

A: The opinion concludes Rule 205 is presumed validly promulgated and preempts the more restrictive North Carolina rule, so following Rule 205 does not expose the lawyer to state discipline.

Q: Does the opinion decide whether SEC Rule 205's "report out" provision is valid?

A: No. The opinion states it is beyond the capacity of an ethics opinion to decide whether Rule 205 was validly promulgated, and it presumes validity unless the Fourth Circuit or the U.S. Supreme Court rules otherwise.

Q: When do the SEC rule and the North Carolina rule actually conflict?

A: Only in the rare case where the conduct the lawyer wants to disclose is not a crime and the lawyer's services were not used to advance it; otherwise Rule 1.6 already permits the disclosure.

Background and rules framework

The opinion interprets North Carolina Rule 1.13 (organization as client, corresponding to Model Rule 1.13) together with Rule 1.6 (confidentiality, corresponding to Model Rule 1.6), against SEC Rule 205 (17 C.F.R. Part 205) issued under Section 307 of the Sarbanes-Oxley Act. It applies federal preemption doctrine from Fidelity Federal Savings & Loan Ass'n v. de la Cuesta and the two-step framework of Chevron U.S.A., Inc. v. Natural Resources Defense Council.

Citations and references

Rules of Professional Conduct:

• MR 1.13 / NC Rule 1.13 (organization as client; (a), (c))
• MR 1.6 / NC Rule 1.6 (confidentiality; exceptions (b)(2), (b)(4))

Statutes and regulations:

• Sarbanes-Oxley Act of 2002, Section 307, 15 U.S.C. § 7245
• SEC Rule 205, 17 C.F.R. Part 205 (Standards for Professional Conduct for Attorneys), §§ 205.3(d)(2), 205.6(c)

Cases:

• Fidelity Federal Savings & Loan Ass'n v. de la Cuesta, 458 U.S. 141 (1982), federal regulation preemption of state law
• Chevron U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984), deference to agency statutory construction

See also

• ABA Formal Op. 514: Advising an Organization on Constituent Legal Risk
• ABA Formal Op. 491: Avoiding Counseling or Assisting Crime or Fraud
• ABA Formal Op. 92-366: Noisy Withdrawal to Avoid Assisting Fraud

Source

• Landing page: https://www.ncbar.gov/for-lawyers/ethics-and-governing-rules/ethics-opinions/opinions/2005-formal-ethics-opinion-9/

Original opinion text

Reproduced from the official source for research purposes. The linked source is authoritative.

Background:

Section 307 of the Sarbanes-Oxley Act of 2002, 15 U.S.C. §7245 ("SOX §307") required the Securities and Exchange Commission (the Commission) to issue rules setting forth minimum standards of professional conduct for attorneys appearing and practicing before the SEC including a rule

(1) requiring an attorney to report evidence of a material violation of securities law or breach of fiduciary duty or similar violation by the company or any agent thereof, to the chief legal counsel or the chief executive officer of the company (or the equivalent thereof); and

(2) if the counsel or officer does not appropriately respond to the evidence (adopting, as necessary, appropriate remedial measures or sanctions with respect to the violation), requiring the attorney to report the evidence to the audit committee of the board of directors of the issuer or to another committee of the board of directors comprised solely of directors not employed directly or indirectly by the issuer, or to the board of directors.

In response to this directive, the Commission adopted Rule 205, Standards for Professional Conduct for Attorneys Appearing and Practicing Before the Commission in the Representation of an Issuer, which became effective on August 5, 2003, 17 C.F.R. Part 205 ("Rule 205"). Section 205.3 of Rule 205 sets forth the duty of an attorney appearing and practicing before the Commission to report evidence of a material violation of securities law or breach of fiduciary duty to the chief legal officer and chief executive officer of the client company and, if an appropriate response is not forthcoming, to the audit committee of the board of directors or to the board itself (commonly referred to as "reporting up"). Paragraph (d)(2) of section 205.3 contains a provision permitting, but not requiring, what is commonly referred to as "reporting out" as follows:

(2) An attorney appearing and practicing before the Commission in the representation of an issuer may reveal to the Commission, without the issuer's consent, confidential information related to the representation to the extent the attorney reasonably believes necessary:

(i) To prevent the issuer from committing a material violation that is likely to cause substantial injury to the financial interest or property of the issuer or investors;

(ii) To prevent the issuer, in a Commission investigation or administrative proceeding from committing perjury, proscribed in 18 U.S.C. 1621; suborning perjury, proscribed in 18 U.S.C. 1622; or committing any act proscribed in 18 U.S.C. 1001 that is likely to perpetrate a fraud upon the Commission; or

(iii) To rectify the consequences of a material violation by the issuer that caused, or may cause, substantial injury to the financial interest or property of the issuer or investors in the furtherance of which the attorney's services were used.

Section 205.6 of Rule 205 addresses sanctions and discipline. Paragraph (c) provides:

(c) An attorney who complies in good faith with the provisions of this part shall not be subject to discipline or otherwise liable under inconsistent standards imposed by any state or other United States jurisdiction where the attorney is admitted or practices.1

Inquiry:

Have the duties of a North Carolina attorney under the Rules of Professional Conduct been affected by the regulations promulgated by the Securities and Exchange Commission under Section 307 of the Sarbanes-Oxley Act of 2002, which authorize a lawyer to disclose confidential or privileged information of a publicly traded company under certain circumstances?

Opinion:

A North Carolina attorney who represents or is employed by a publicly traded company and who appears and practices before the Commission faces a potential dilemma. Pursuant to Rule 205, under certain circumstances such an attorney may disclose or "report out" corporate confidential information relative to a material violation of securities law, breach of fiduciary duty, or similar violation by the corporation. Nevertheless, under Rule 1.13(c) of the North Carolina Rules of Professional Conduct, an attorney for any organization, whether it is a publicly traded company or not, who has fulfilled the duty set forth in Rule 1.13(a) to report internal misconduct to the highest authority for the organization and the highest authority insists upon action, or a refusal to act, that is clearly a violation of law and is likely to result in substantial injury to the organization, may reveal confidential client information outside the organization only to the extent permitted by Rule 1.6, the confidentiality rule (Rule 1.13 and Rule 1.6 collectively are referred to as the "NC Rule"). In this situation, disclosure outside the organization might be permitted by Rule 1.6(b)(2), which allows disclosure of client confidences to prevent the commission of a crime by the client, or Rule 1.6(b)(4), which permits disclosure of client confidences to prevent, mitigate, or rectify the consequences of a client's criminal or fraudulent act in the commission of which the attorney's services were used. However, in the rare instances that the activity that a North Carolina attorney desires to disclose pursuant to Rule 205 does not involve a crime or the attorney's services were not used to advance the activity, the attorney may not know whether he or she faces professional discipline if the attorney chooses to "report out."

The potential conflict between Rule 205 and the NC Rule raises the question of whether the NC Rule is preempted by Rule 205. A federal regulation validly promulgated carries the force of federal law, with no less preemptive effect than federal statutes. Fidelity Federal v. de la Cuesta, 458 U.S. 141 (1982). According to de la Cuesta, the questions upon which resolution of preemptive effect of a regulation rests is whether the agency means to preempt state law, and if so, whether that action is within the scope of the agency's delegated authority. de la Cuesta at 154. The Commission's intention to preempt state ethics rules conflicting with Rule 205 is unambiguous. In its letter discussing the implementation of the final version of Rule 205, the Commission states:

The language we adopt today clarifies that this part does not preempt ethical rules in United States jurisdictions that establish more rigorous obligations than imposed by this part. At the same time, the Commission reaffirms that its rules shall prevail over any conflicting or inconsistent laws of a state or other United States jurisdiction in which an attorney is admitted or practices.1

In determining whether the regulation is validly promulgated, the courts are directed by the Supreme Court in Chevron USA, Inc. v. Natural Resources Defense Council, Inc., 457 U.S. 837 (1984) to conduct a two-prong inquiry. First, the court must determine whether Congress has directly spoken on the precise question at issue (the "First Prong"). However, if Congress has not addressed the precise issue and the statute is ambiguous, then the question is whether the agency's interpretation of the statute and the regulation promulgated is based on permissible construction of the statute (the "Second Prong"). SOX §307 mandates the Commission to require "reporting up" in its regulations There is no provision in SOX, however, that expressly authorizes the Commission to adopt "reporting out" regulations. Good faith arguments can be made for both propositions, i.e., that SOX does, and does not, implicitly grant such authority to the Commission.

It has been argued that there is no conflict between Rule 205 and the North Carolina Rules. Because Rule 205 is permissive, the argument goes, one can comply with a more stringent state requirement while not offending federal law, i.e. compliance with both regulatory regimes is not a "physical impossibility." Once again, de la Cuesta is instructive. In that case, the court noted that the more stringent state law effectively created an obstacle to the achievement of "the full purposes and objective" of the federal regulation. Following the reasoning in de la Cuesta, the NC Rule undeniably impinges on the flexibility provided by Rule 205, and a reviewing court would likely hold that if Rule 205 was validly promulgated, it preempts the NC Rule.

It is beyond the capacity of an ethics opinion to determine whether or not the "reporting out" provision of Rule 205 was validly promulgated. Therefore, unless and until the Fourth Circuit Court of Appeals or the US Supreme Court determines that Rule 205 was not validly promulgated, (a) there will be a presumption that Rule 205 was promulgated by the Commission pursuant to a valid exercise of authority and (b) a North Carolina attorney may, without violating the North Carolina Rules of Professional Conduct, disclose confidential information as permitted by Rule 205 although such disclosure would not otherwise be permitted by the NC Rule.

End Notes

• US Securities & Exchange Commission, Final Rule: Implementation of Standards of Conduct for Attorneys, Release Nos. 33-8185, 34-47276, IC-25929, republished in Practicing Law Institute, Corporate Law and Practice Course Handbook Series 489, 494 (May 2005).