Board Involvement in Corporate Ethics Codes - Corporate Governance and Business Ethics

The first governance topic to be discussed is the board’s role in ensuring that firms conduct their activities ethically. Since the board oversees the firm’s management, it plays an important role in the “tone at the top” of the firm. The “tone at the top” of a firm helps set expectations for firm conduct.

The Sarbanes-Oxley Act (hereafter referred to as SOX) requires firms to disclose whether they have adopted codes of ethics for their senior financial officers and if not, why they have chosen not to do so (Subsection A). SOX defines codes of ethics in terms of promoting “the ethical handling of actual or apparent conflicts of interest between personal and professional relationships” (Subsection C, point 1) and “full, fair, accurate, timely, and understandable disclosure in the periodic reports required to be filed by the issuer” (Subsection C, point 2). This supports the notion that conflicts of interest and transparency are both ethical issues. In addition, both the NYSE and Nasdaq have implemented rules requiring listed firms to adopt codes of ethics that apply to all employees, executives, and directors. Firms must also disclose amendments to their codes and any time when code provisions are waived for any reason. This is most likely in response to the revelation that Enron waived its code without informing its shareholders on three occasions in order to allow the firm to conduct business with partnerships involving CFO Andrew Fastow.

An implicit assumption underlying these requirements is that an ethics code will help a firm develop a more forthcoming and transparent attitude concerning its; disclosures. This view is consistent with the conclusion of the National Commission on Fraudulent Financial Reporting (“Tread way Commission”) that firms could enhance the quality of their financial reports by strengthening their internal control environments through formal ethics programs, including ethics codes (National Commission on Fraudulent Financial Reporting 1987). Is there empirical evidence to support this expectation? Brief et al. (1996) conduct an experiment concerning the relationship between the adoption of a code and financial reporting quality. Their results imply that simply requiring firms to adopt codes will not improve financial reporting transparency.

Brief et al.’s (1996) results do not support mandatory ethics codes. However, it is possible that simply implementing a code is insufficient to change people’s behavior. This could be because a code without sufficient involvement from executives and directors is seen as “window dressing”. If this is the case, then it is unlikely that an ethics code will result in greater transparency. This could be what happened at Enron when its board suspended its code as noted above. Possibly in response to this, the Federal Sentencing Guidelines in the United States were revised in 2004 to encourage greater board participation in corporate ethics programs (Hoffman and Rowe 2007). The assumption behind this change is that greater board participation will reduce the likelihood that an ethics program is viewed as simply “window dressing”.

What activities can a board perform to demonstrate a greater commitment to a firm’s ethics program? Generally speaking, a board can demonstrate its commitment to a firm’s ethics program by overseeing the operation of the program. For example, board members may receive reports concerning the status and resolution of calls to the firm’s “ethics hotline”, review results of “ethics audits”, assist in the modification of the firm’s ethics code as needed, and review the adequacy of resources allocated for the firm’s ethics training sessions. Also, board members can demonstrate the importance of the firm’s code by at least partially basing executive compensation on adherence to the firm’s code. Johnson & Johnson is an example of a firm that does this. A board can form a standing ethics committee to oversee the program, assign oversight of the firm’s ethics program to one of its other standing committees (e.g., the audit or compensation committee), or reserve responsibility for overseeing the program for the board as a whole.

Evidence from Felo (2006) indicates that board oversight has become much more common. In his 1995 sample, approximately 27% of sample boards provided oversight for their ethics programs. By 2001, over 70% of boards provided oversight for their programs. In addition, his results indicate that in 1995 oversight was limited to boards of relatively large firms. In 2001, however, there are no significant differences in firm size between “oversight” and “no oversight” firms.

Is board involvement in ethics programs related to disclosure transparency? Using data predating SOX and the Tread way Commission, Felo (2000) reports that financial analysts find the disclosures made by firms having ethics programs overseen by their boards to be more credible than disclosures made by other firms having ethics programs not overseen by their boards and by firms not having formal ethics programs. These results show the important role board oversight plays in attempts to design regulations to improve disclosure transparency. Using the same measure of disclosure transparency, Felo (2006) reports that firms adding ethics programs overseen by their boards between 1995 and 2001 were more likely to increase their financial disclosure credibility than were other firms. This is important evidence as it demonstrates that board oversight of ethics programs can lead to improvements in disclosure transparency. Using a different measure of disclosure transparency, Felo (2007) finds that firms with boards involved in their corporate ethics programs display more transparency than do other firms. For example, they are more likely than other firms to have voluntarily provided information concerning board nominating committees and processes for communicating with directors before this information was mandated by the SEC in 2003. All of these results indicate that going beyond SOX requirements, extending an ethics code throughout an organization, and having the board oversee its development, implementation, and maintenance may result in a more transparent corporate attitude.

As noted above, one dimension of corporate ethics codes according to SOX is the handling of potential conflicts of interest. Consequently, an implicit assumption underlying SOX is that an ethics code will help a firm better manage potential conflicts of interest that may arise in its operations. What is the empirical evidence related to this? Felo (2001) finds that boards actively involved in their ethics program are more independent than are boards at other firms (whether those firms have ethics programs where boards are not involved or whether those firms have no formal ethics program). In addition, compensation committees are more independent at firms where boards are actively involved in ethics programs than at other firms. Since non-independent boards and compensation committees can enrich management at the expense of shareholders, these results indicate that board oversight (and just the existence of an ethics code) can help protect shareholders from being exploited by corporate insiders. Like the results from the disclosure transparency research, these results support the notion that board oversight is an important factor in whether an ethics program is related to fewer conflicts of interest in corporate governance.

In summary, extant research indicates that boards play an important role in determining whether ethics codes reduce the likelihood of unethical corporate behavior. As a result, regulators may want to implement rules mandating board oversight of corporate ethics codes. Absent this mandate, boards may want to voluntarily begin overseeing the development, implementation, and maintenance of their ethics codes.

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Corporate Governance and Business Ethics Topics