When the Securities and Exchange Commission settled charges against the former general counsel for Electro Scientific Industries, it certainly seemed like the first case involving the so-called "up-the-ladder" provision of Sarbanes-Oxley.
Section 307 of SOX sets "standards of professional conduct for attorneys appearing and practicing before the Commission in any way in the representation of issuers." The section requires an attorney to report evidence of a material violation up-the-ladder to the chief legal counsel or the chief executive officer of the company. If the CLO or CEO doesn't respond appropriately, the lawyer must report the evidence to the audit committee, another committee of independent directors, or the full board of directors.
The settlement in question, which specifically noted that the lawyer failed to provide appropriate information and advice to the company's audit committee and board of directors, certainly sounded like a violation of Sarbanes-Oxley Section 307.
But experts say that SOX 307 may not have been at work, and that in fact the case was a "garden variety" negligence case.
The Details
Dooley
Isselmann
On Sept. 23, the SEC filed financial fraud charges against James T. Dooley, ESI’s former chief financial officer, chief operating officer and then-chief executive officer, and James E. Lorenz III, the company’s former corporate controller, alleging they engaged in accounting fraud.
In a separate settled enforcement action, the Commission charged that John E. Isselmann, Jr., ESI’s former general counsel, failed to provide important information to ESI’s audit committee, board, and auditors related to the accounting fraud.
The Commission’s lawsuit against Isselmann alleges that he omitted to state necessary material facts to ESI’s auditors. “Isselmann failed to provide important information to ESI's audit committee, board of directors, and auditors regarding a significant accounting transaction that enabled ESI to report a profit rather than a loss,” the SEC asserted. “Isselmann's failure to fulfill his gatekeeper role was a cause of the company reporting materially false financial results for ESI's first quarter ended Aug. 31, 2002.”
The SEC alleged that Dooley and Lorenz had fraudulently decided to eliminate vested retirement and severance benefits for ESI's Asian employees in order to boost earnings by $1 million. It further charged that Isselmann later received written legal advice that the law prohibited the unilateral elimination of the benefits.
“Despite having opportunities to provide the advice to ESI's audit committee, board of directors, and auditors, Isselmann failed to do so,” the SEC’s complaint states. “Isselmann's failure allowed the CFO and controller to hide an ongoing fraud. Moreover, while in possession of the written legal advice stating that the law prohibited the unilateral elimination of the benefits, Isselmann was involved in the review process for ESI's quarterly report filed with the Commission describing the elimination of the benefits and the resulting impact on ESI's income.”
Up-The-Ladder Violation, Or Not?
So if failure to report up-the-ladder was mentioned in the settlement, why wasn't Isselmann cited under Section 307 of SOX?
Though the SEC would not speak on the record, a source at the Commission did acknowledge that Section 307 of Sarbanes-Oxley was not at work in the Isselmann case.
Sauer
Richard Sauer, a former assistant director with the SEC's Division of Enforcement asserts, “The conduct at issue here seems to be close to what might now be construed as a failure to report up the ladder, but instead was treated as garden variety negligence by a corporate officer involved in the disclosure process who also happened to be an attorney." According to Sauer, now a partner at Vinson & Elkins, Isselman's legal position only mattered inasmuch as he should have known how to comport himself. "His status as an attorney was the source of his liability only in that his position as general counsel led to a situation in which he had certain knowledge which the SEC alleged should have caused him to conclude that inaccurate information had been provided to the company's auditors and Audit Committee.”
Another securities law expert believes the SEC might not have invoked SOX 307 because the individual himself was the chief legal counsel. In effect, Isselmann was already sitting “up the ladder” to begin with. He didn’t have anyone higher to report the violations to, the argument goes. “He is not required to report himself,” adds the expert. Others disagree, noting that even a chief legal officer would be required to report up to a CEO or board.
Perhaps the overriding reason this case was not prosecuted under Section 307 is because the attorney’s infraction took place during the middle of 2002.
The SEC adopted final rules to implement Section 307 on Jan. 23, 2003.
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