BUSINESS & SECURITIES

Corporate Governance:
Codes of Ethics to Guide Corporate Conduct

July 2002

By Susan B. Hollinger*

Every day, no matter where we turn, the news is not pleasant for corporate America. The names "WorldCom" and "ENRON" are now part of our everyday vernacular. We see and feel the fallout from a sluggish stock market, layoffs, and general distrust of anything corporate. Significant amounts of invested capital have been lost due to allegations of corporate malfeasance and "insider abuse". Recent allegations of new scandals and a general perception of mistrust and uncertainty are directly impeding the ability of companies to compete, create jobs and improve our economy.

There are new and proposed Securities and Exchange Commission rules, national stock exchange listing requirements, and sweeping new legislation which passed both sides of Congress, signed by President Bush, creating new structures for the regulation of the accounting industry as well as incentives to manage fraud in the form of harsher penalties for corporate misconduct. Although these requirements are largely directed at publicly traded businesses and other government-regulated industries, these new laws should cause management and Boards of Directors, whether of public or closely held businesses, to take the call for corporate reform to heart by establishing or reassessing their company's code of ethics. Effective corporate governance is one that is based on a core set of ethical principles that guide the company's actions, whether to rollout a new product or raise new capital. It establishes a framework for effectively assessing risk and detecting and preventing fraud and abuse by corporate insiders.

All businesses want to grow the company and thus need competent senior management. However, competent management does not mean that the only criteria are knowledge about the operations of the business and the ability to increase income, growth and profits. Competent management should also inculcate a culture of honesty and ethical behavior. The Board of Directors and management should set appropriate ethical examples for all employees, top to bottom.

An effective code of ethics or code of conduct is one that is adopted by the Board of Directors and regularly reviewed and reaffirmed by the Board. A code of ethics should set out the values of the company such as leadership, responsibility, honesty, and commitment but not stop there. A code of ethics should not be one merely consisting of empty phrases, or, as Thomas Stewart, the editorial director of Business 2.com puts it, "bullet-pointed lists of vacuous high-mindedness". Mr. Stewart has noted that ENRON had a value statement that listed such generic items as 'integrity', 'respect', 'communication' and 'excellence'. We know now how effective their value statement was in guiding the conduct of their officers.

For starters, codes of conduct should address working conditions, employee development and training, and conflicts of interest. What is a conflict of interest? The term refers to a wide range of activities by key people in a company, such as officers, directors and employees who act in order to benefit themselves at the expense of the business. It may involve excessive stock options and compensation, sweet deals that take profits that belong to the company and redirect them to the insiders, or loans to directors or highly placed managers at extraordinary favorable rates and terms.

What can be done to effectively control conflicts of interest before they mushroom into insider fraud and abuse? Many things, from adopting a code of ethics, conducting fraud risk assessment, outside audits, through restructuring the power and makeup of Boards of Directors. The first step, however, is to create a management structure that allows the company to grow in an ethical manner. Effective codes should require disclosure by Directors, officers or employees, of the existence of an ownership interest, either directly or indirectly (such as through an immediate family member, trust or other arrangement), in any entity which (i) competes with the current or planned business of the company; or (ii) supplies goods or services to the company.

Disclosure is not enough, either. Internal procedures should be in place to deal with disclosed conflicts of interest situations. For example, participation by an employee or a member of its immediate family in a transaction between the business and an entity in which the employee has a significant financial interest should require approval of either a supervisor or a majority of disinterested Board members, depending on whether the amount of money involved is nominal or not. Board minutes should be complete and accurate as to the disclosure, discussion and procedure. Approval should be conditioned on independent verification of the technical specifications of the job to be performed and the reasonableness of the price to be charged.

Personal use of company resources, such as company facilities and equipment for personal activities above a nominal amount is another example. Again, disclosure is advised and approval should be conditioned on reimbursement to the company of costs.

Solicitation or receipt of gifts or loans from those who provide goods or services to the business should not be permitted above a certain amount. Overlooking expensive gifts and loans more favorable than market terms smell of bribery, or, at the very least, attempts to exercise undue influence on what should be the independent judgement of the recipient.

Codes of conduct might also want to address situations in which a Director, officer or employee uses the company name in non-company situations that imply that the company endorses or sponsors the private activity. For example, company stationary should not be used if an employee is writing a letter to the editor on a controversial topic unless the Board has directed such a letter be published on its behalf. Employee viewpoints may be expressed in public situations, but a clear separation should exist between company endorsement and personal viewpoints.

To be truly effective, an ethics code should be incorporated into employee training throughout the company and used as a tool for aiding worker sensitivity regarding expected behavior. It should also be monitored at all levels to determine whether the principles are actually implemented throughout the company. It does no good to have an extensive section on working conditions if, for example, a middle manager ignores company procedures and policies and fails to supervise a night shift employee who sexually harasses another employee. Many companies with ethics programs have continued to incur large legal costs for litigation based on unethical behavior of its employees because of gaps in supervising and enforcing an ethical code of conduct. The continued employment of all employees, as well as service by Board members, should in part be determined on each person embracing, enforcing and conducting themselves according to an appropriate ethical code of conduct.

*Susan B. Hollinger is admitted in New Hampshire and Massachusetts.

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