The SEC’s Part 205.3(d)(2) and Wadler v. Bio-Rad Labs. Should Be Revisited: The SEC Exceeded Authority in Creating a Reporting Out Provision for In-House Attorneys

Congress passed the Sarbanes-Oxley Act of 20021Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, 116 Stat. 745 (codified as amended in scattered sections of 15 and 18 U.S.C.). in response to corporate and accounting scandals, including those at Enron and WorldCom.2See The Dramatic Change Across the Corporate Landscape to Re-Establish Investor Confidence in the Integrity of Corporate Disclosures and Financial Reporting: Hearing on Implementation of the Sarbanes-Oxley Act of 2002 Before the S. Comm. on Banking, Hous. & Urban Affairs 108th Cong. 6 (2003) (statement of William H. Donaldson, Chairman, U.S. Sec. & Exch. Comm’n). When the fraud and accounting scandals came to light, the share prices of these companies plummeted, costing investors billions of dollars.3See id. The rules the Sarbanes-Oxley Act directed were not limited to those addressing accounting practices.4See, e.g., 15 U.S.C. § 7245 (2018). Some provisions were aimed at attorney practices.5See id.

Section 307 of the Sarbanes-Oxley Act directed the Securities and Exchange Commission (SEC) to create rules setting forth standards of professional conduct for attorneys.6See id. The SEC implemented Part 205 of Title 17 of the Code of Federal Regulations7Standards of Professional Conduct for Attorneys Appearing and Practicing Before the Commission in the Representation of an Issuer, 17 C.F.R. § 205 (2003). in response to Section 307 of the Sarbanes-Oxley Act, which attorneys “appearing and practicing” before the SEC must follow.8Final Rule: Implementation of Standards of Professional Conduct for Attorneys, Sec. & Exchange Commission, https://‌www.sec.gov/‌rules/‌final/‌33-8185.htm [https://‌perma.cc/‌S4EX-ZADP] (last updated Sept. 26, 2003) (Section 205.3(a)). In clarifying “appearing and practicing,” Senator Enzi stated this refers to “just attorneys appearing and practicing before the Commission; that is, those who are dealing with documents that deal with companies listed by the Securities and Exchange Commission.” 148 Cong. Rec. S6551–55 (daily ed. July 10, 2002) (Amendment No. 4187) (statement of Sen. Enzi). Part 205 contains two main provisions.9See 17 C.F.R. § 205. Part 205.3(b) contains a comprehensive, mandatory reporting-up provision, which details the process an attorney representing an issuer must take in reporting up the ladder in the company if she discovers evidence of a material violation10Part 205.2(e) defines evidence of a material violation as “credible evidence, based upon which it would be unreasonable, under the circumstances, for a prudent and competent attorney not to conclude that it is reasonably likely that a material violation has occurred, is ongoing, or is about to occur.” Id. Senator Edwards stated, “[f]irst, the way we have drafted the bill, the duty to report applies only to evidence of a material violation of the law. That means no reporting is required for piddling violations or violations that don’t amount to anything. The obligation to report is triggered only by violations that are material—violations that a reasonable investor would want to know about. So we have been very careful there.” See 148 Cong. Rec. at S6552. of securities laws.11See 17 C.F.R. § 205.3(b). Part 205.3(d) contains a permissive reporting out provision, in which the attorney may report out evidence of the material violation to the SEC.1217 C.F.R. § 205.3(d).

This reporting out provision conflicts with the ethics laws of many states.13For a discussion on state laws that conflict with Part 205.3(d)(2), see infra Section I.C.. For example, Part 205.3(d)(i) permits reporting out in order to prevent substantial injury to the financial interest or property of the issuer company or the company’s investors.14See 17 C.F.R. § 205.3(d)(i). However, New York’s Rules of Professional Conduct allow an attorney to report out in order to prevent death or substantial injury, and thus prevention of financial injury is not an exception in which an attorney may report out.15See infra Section I.C. These circumstances, where Part 205.3(d) allows reporting out but state law prohibits disclosure of the same information, leave attorneys in conflict about whether they may or may not legally report violations to the SEC.16For a discussion on the different ways in which state bar associations in states with more limited confidentiality disclosure laws have responded to the conflict between Part 205 and their respective states laws, see infra Section I.C.

The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act)17Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376 (2010) (codified as amended in scattered sections of 12, 15, and 26 U.S.C.). built on the Sarbanes-Oxley Act, following the stock market crash of 2008. The Dodd-Frank Act implemented broad changes to corporate regulation, including the expansion of oversight of financial companies, regulations on credit rating agencies, and oversight regarding corporate governance matters.18See generally Morrison & Foerster, The Dodd-Frank Act: A Cheat Sheet (2010), http://‌media.‌mofo.com/‌files/‌uploads/‌Images/‌SummaryDodd‌FrankAct.pdf [https://‌perma.cc/‌7F6D-Z9HG] (providing a summary of the principal aspects of Dodd-Frank). Section 922 of the Dodd-Frank Act creates further conflict with state law.19See Press Release, Sec. & Exch. Comm’n, SEC Adopts Rules to Establish Whistleblower Program (May 25, 2011), https://‌www.sec.gov/‌news/‌press/‌2011/‌2011-116.htm [https://‌perma.cc/‌5RG6-5778]; Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376 (2010). Section 922 creates a whistleblower bounty program, whereby individuals who disclose original information may receive payments based on successful civil penalties.20See Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376, § 922 (2010). This section sets forth monetary incentives and protection for whistleblowers, including an award to whistleblowers who voluntarily provided original information to the SEC that led to the successful enforcement of a covered judicial or administrative action brought by the SEC under the securities laws that results in monetary sanctions exceeding $1 million. It allows an award in an aggregate amount of between ten and thirty percent of the monetary sanctions collected. See Frequently Asked Questions, Sec. & Exchange Commission: Off. Whistleblower, https://‌www.sec.gov/‌whistleblower/‌frequently-asked-questions#faq [https://‌perma.cc/‌DST4-WEHL] (last updated Oct. 29, 2018). If a successful civil penalty results, the whistleblower may receive an award between ten and thirty percent of the imposed penalty.21See Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376 (2010. However, this reward poses a potential conflict with state ethics laws prohibiting attorneys from representing clients in situations in which there are conflict of interests.22See, e.g., N.Y. Cty. Lawyers Ass’n Comm. on Prof’l Ethics, Formal Op. 746 (2013), https://‌www.nycla.org/‌siteFiles/‌Publications/‌Publications1647_0.pdf [https://‌perma.cc/‌2BBM-FMQ4]. The opinion states “[a] lawyer who blows the whistle prematurely could harm the client and be professionally responsible for the precipitous disclosure of client confidences.” Id. at 10. However, this Note examines the issue of whether Part 205 may preempt state law itself, rather than whether attorneys who disclose confidential information about their in-house clients may then collect a bounty.

This Note proceeds in three parts. Part I introduces relevant statutory law. Part I discusses federal law, notably Section 307 of the Sarbanes-Oxley Act and the SEC’s Part 205.3(d)(2), as well as the American Bar Association (ABA) Model Rules and conflicting state law. Part II first examines case law involving the preemption of state ethics laws, including Wadler v. Bio-Rad Laboratories, which concluded broadly that Part 205 preempts California law.23See Wadler v. Bio-Rad Labs., Inc., 212 F. Supp. 3d 829 (N.D. Cal. 2016). Part II then examines the doctrine of federal preemption, which is followed by a preemption analysis of Part 205.3(d)(2). Part III recommends that Part 205.3(d)(2) should be revisited, as the SEC did not act within its statutorily authorized power in promulgating the rule.

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