December 19, 2002
Securities and Exchange Commission
Re: File S7-40-02
Ladies and Gentlemen:
This letter is submitted on behalf of the Committee on Federal Regulation of Securities of the American Bar Association's Business Law Section (the "Committee")1 in response to the request of the Securities and Exchange Commission (the "Commission") for comments on the proposed rules implementing Sections 404, 406 and 407 of the Sarbanes-Oxley Act of 2002 (the "Act"). It relates to the Commission's proposal under Section 406 of the Act regarding codes of ethics. We are separately commenting on the proposals under Sections 404 and 407.
The comments expressed in this letter represent the views of the Committee only and have not been approved by the American Bar Association's House of Delegates or Board of Governors and therefore do not represent the official position of the Association. In addition, this letter does not represent the official position of the ABA Section of Business Law; nor does it necessarily reflect the views of all members of the Committee.
Section 406 of the Act directs the Commission to issue rules requiring all reporting companies to disclose whether they have a code of ethics applicable to senior financial officers. The Commission's proposal under Section 406 would require every reporting company to disclose in its annual report whether it has adopted a code that applies not only to its senior financial officers, but also to its principal executive officer. In addition, companies would be required to file their code of ethics as an exhibit to each annual report on Form 10-K. Finally, the proposal would require prompt disclosure, on Form 8-K or the company's website, of any changes to or waivers from the code of ethics.
As a threshold matter, the Committee believes that the Commission should be commended for its efforts to improve transparency relating to corporate codes of ethics by implementing Section 406. We are concerned, however, about areas in which the Commission has gone beyond the narrow directive in Section 406, which focuses on financial reporting and senior financial officers. As discussed below, Section 406 was intended specifically to enhance the reliability of financial reporting. Expanding this narrow focus to include other issues and groups beyond the scope of the financial reporting process may cause confusion and duplication of requirements and may unnecessarily involve the Commission in the internal affairs of companies. In this regard, the New York Stock Exchange ("NYSE") and the NASDAQ Stock Market Inc. ("NASDAQ") recently proposed new corporate governance listing standards requiring listed companies to have comprehensive codes of conduct covering officers, directors and employees. Once experience has been gained under the proposed listing standards, the Commission can consider whether any additional measures are appropriate for non-listed companies.
Our specific comments address five aspects of the proposal: (1) relationship to existing codes of ethics; (2) persons to whom the code of ethics must apply; (3) content of the code of ethics; (4) changes to the code of ethics; and (5) waivers of the code of ethics.
Relationship to Comprehensive Codes of Ethics
A great many corporations have, and have had for some time, a comprehensive code of ethics that applies to all employees, including the chief executive officer and the officers concerned with finance and accounting. Company codes of ethics often cover a variety of subjects, including conflicts of interest, legal compliance, confidentiality policies, the use of inside information, and employment policies dealing with such issues as discrimination and harassment, equal opportunity, and health and safety. We believe the Commission's Section 406 rule needs to accommodate these comprehensive codes as discussed below.
The Commission's proposal would impose a detailed definition of "code of ethics" and would require companies to disclose whether or not they have a code of ethics meeting that definition. Although we recognize that the proposal is disclosure-based and would not require companies to adopt particular code provisions, we believe that most companies will take steps to avoid disclosing to investors that they do not have a code of ethics meeting the Commission's requirements. We are concerned that the adoption of a detailed Commission rule for codes of ethics may cause many companies to create multiple codes for different groups of officers, directors and employees. For example, a company might maintain one code covering all officers and directors (and dealing with a broad range of issues) and a separate, so-called Section 406 Code of Ethics designed solely to meet the Commission's requirements. As a result, senior officers would be expected to comply with multiple codes of conduct, with overlapping and potentially duplicative provisions.
We also are concerned about the requirement that companies file their code of ethics as an exhibit to annual reports on Form 10-K. We believe the Commission should revise its proposal to permit companies to file only those code provisions covered by Section 406 (rather than the entire code of ethics). As noted above, a company's code of ethics sometimes includes a voluminous set of corporate policies, which deal in depth with the areas covered by the code. To require the filing of these extensive documents would be very burdensome and would not inform investors about the financial reporting issues targeted by Section 406.
Also, as discussed below, we suggest that the Commission clarify that only those changes and waivers relating to matters covered by the Commission's Section 406 rule need be promptly disclosed on Form 8-K or company websites. We believe that these modifications of the proposal are necessary to permit companies to continue to maintain a single, comprehensive code of ethics applicable to all officers and employees - rather than create a separate Section 406 Code of Ethics.
Persons to Whom the Code of Ethics Must Apply
The proposal would require companies to disclose whether they have a code of ethics that applies not only to senior financial officers (as mandated by Section 406) but also to the principal executive officer. Further, the Commission is seeking comments on whether it should expand its proposal to cover an even broader group of persons, including the general counsel, all executive officers and even directors.
Section 406 was intended to enhance the reliability of financial reporting by providing greater transparency regarding codes of ethics applicable to senior financial officers, who are responsible for financial reporting and disclosure processes. The Act is specific as to the officers covered, and we do not believe the Commission should go beyond the statutory authorization in an area that involves the internal affairs and governance mechanisms of companies. Section 406's focus on senior financial officers is consistent with the policies of organizations such as Financial Executives International ("FEI").
The Committee also is concerned that expanding this narrow mandate to encompass additional officers - including the chief executive officer and possibly other executive officers and even directors - may cause unnecessary confusion and duplication of requirements. As noted above, the NYSE and NASDAQ recently proposed new corporate governance listing standards requiring listed companies to have comprehensive codes of conduct covering all officers, directors and employees. The proposed listing standards address a number of issues covered by the Commission's proposal, including conflicts of interest, compliance with applicable laws and regulations, internal reporting of code violations, and waivers of the code. Rather than expanding the Sarbanes-Oxley Act directive applicable to senior financial officers, we believe the Commission should focus its efforts on the individuals responsible for financial reporting, as the Act envisions, and permit the NYSE and NASDAQ to address codes of conduct for broader groups in their listing standards.
Content of the Code of Ethics
The proposal includes a detailed, six-part definition of the term "code of ethics." As proposed, the term "code of ethics" means a codification of standards that is reasonably designed to deter wrongdoing and to promote:
If a company's code does not satisfy all six parts (three of which are not found in Section 406), the company will be unable to state in its annual report that it has the type of code contemplated by the proposal.
Section 406 defines "code of ethics" to encompass areas that companies have traditionally included in their codes of conduct. The additional requirements proposed by the Commission, relating to disclosure of conflicts of interest to an "appropriate person or persons," internal reporting of code violations to an "appropriate person or persons" and "accountability for adherence to the code," are far less clear. The proposing release provides little guidance regarding disclosure and reporting to the "appropriate person or persons" and does not explain the statement that a company's code should address "accountability for adherence to the code." The Committee is concerned that these requirements - and the Commission's comment that it may require a company to "describe its procedures to ensure compliance with the code of ethics" - may unnecessarily involve the Commission in the internal affairs of companies. In addition, Instructions 1(a) and 1(b) to proposed Item 406, which include the first two bullet points listed above, address conflicts of interest in a confusingly similar and somewhat overlapping way. The Committee suggests that the Commission could avoid unnecessary confusion by combining Instructions 1(a) and 1(b) into a single point.
As discussed above, the NYSE and NASDAQ have proposed to require listed companies to have broad codes of conduct addressing a number of issues. The Committee believes that the Commission's proposed code of ethics requirements, many of which overlap with (and to some extent duplicate) NYSE and NASDAQ proposals, would only confuse and complicate the issues for companies attempting to comply with both standards. Instead, the Committee suggests that the Commission limit its rule to those matters set forth in Section 406 and permit the NYSE and NASDAQ to address broader code of conduct requirements for listed companies.
Changes to the Code of Ethics
The proposal would require the prompt disclosure (on Form 8-K or the company's website) of any change to the company's code of ethics. As noted above, many public companies already maintain comprehensive codes of conduct covering any number of issues, from employment discrimination to conflicts of interest to confidentiality policies. Requiring the prompt disclosure of any change to a company's code of ethics would implicate changes to all parts of the code or codes, not merely the narrow provisions covered by Section 406. As written, the proposal would mandate disclosure of changes to parts of codes that have nothing to do with financial accountability, the intended focus of Section 406. Moreover, the proposal does not distinguish between material and immaterial changes to the code.
It would be impracticable for companies to promptly report changes to all parts of their codes of conduct. Instead, a company likely would elect (as discussed above) to adopt a separate Section 406 Code of Ethics, which would permit the company to report changes made to the relevant provisions. The Committee is concerned that this would make compliance with codes of conduct needlessly complicated and confusing for officers and employees, who would be expected to comply with multiple codes of conduct. Furthermore, mandating the disclosure of all changes, whether or not material, would not be helpful to investors (and indeed could unnecessarily alarm them) and may inundate the Commission with filings of little or no value. We suggest that the Commission revise its proposal to require prompt disclosure of material changes to the particular provisions of a code of conduct with which the Commission's Section 406 rule is concerned (conflicts of interest, disclosure, and legal compliance by covered officers). Such a revision would permit companies to maintain a single code of ethics for officers and employees, without having to report material changes outside the scope of Section 406.
Waivers of the Code of Ethics
The proposal also would require prompt disclosure of any waiver of a company's code of ethics granted to the chief executive officer or senior financial officers, including an "implicit waiver" due to inaction on the part of the company with respect to a reported or known violation of a code provision. In the proposing release, the Commission requests comment on whether the term "waiver" is a sufficiently distinct and formal event that the obligation to disclose waivers will not present any difficulties of interpretation.
We believe that the term "waiver" is sufficiently ambiguous so as to present significant problems of interpretation, and the term "implicit waiver" provides still greater ambiguity. For example, a decision not to discipline a person for a code violation, a decision to only reprimand a person for a code violation, or a decision that particular conduct does not constitute a code violation as a result of factual investigation or code interpretation should not be deemed "waivers," but might be under the proposal. Although the Commission states in the proposing release its belief that waivers "will be relatively rare events," we are not convinced that this will be the case because the number of waivers will vary depending on how codes are drafted. We also are concerned that absent a clear definition of what constitutes a waiver, any final rule could be interpreted to require disclosure of a broad range of actions by a company. This is particularly true in situations where a company reasonably concludes that no waiver has occurred but, lacking clear guidance and out of an abundance of caution, elects to disclose an event that the Commission would not deem a waiver. We believe that the result will likely be a flood of filings or web postings reporting routine internal company determinations. This would be costly and time-consuming for companies, would be of little or no value to investors, could unnecessarily alarm investors, and would obscure the material matters with which Section 406 is concerned. Moreover, information regarding material transactions with management and others already is required to be disclosed in proxy statements and reports on Form 10-K under Item 404 of Regulation S-K.
We believe the Commission can prevent much confusion and unnecessary paperwork by removing the reference to "implicit waivers" and indicating that the situations described above will not be considered waivers under the final rule. In addition, we suggest that the Commission avoid distinguishing between degrees of discipline imposed by a company for code violations. Many companies are restricted in the types of discipline they may impose on certain employees and require flexibility in crafting disciplinary measures for code violations.
Finally, the proposing release solicits comment on whether there are any privacy concerns that would warrant narrowing the disclosure requirements regarding code waivers. The Committee believes that the proposal, which requires disclosure of the name of the officer to whom a waiver is granted and the nature of the waiver, raises serious privacy concerns. Most codes of conduct cover areas where there are no bright-line tests, only a general principle requiring employees to seek the approval of their supervisors. For example, many codes prohibit the receipt of "lavish" gifts or entertainment, but leave it to supervisors to determine, based on the specific facts, whether a particular gift is lavish. Under the proposal, it is not clear whether each gift approved by a supervisor would constitute a reportable "waiver." In addition, many companies maintain conflict-of-interest provisions prohibiting employees and officers from hiring or doing business with family members. In remote locations, however, an officer's relative may be the only source available to fill the company's needs. It is not clear whether the company would be required to report any dealings with the officer's relative as "waivers" under the proposal. As noted above, any "waiver," whether material or not, would trigger an obligation to report the name of the officer to whom the waiver is granted and the nature of the waiver, information that could be particularly sensitive for officers and their relatives. For this reason, we are concerned that the Commission's proposal may unnecessarily intrude on officers' privacy and encourage them to hide actions that the code of ethics is intended to prevent or limit. To avoid this problem, we suggest that the Commission revise its proposal to require disclosure only of the existence and nature of material waivers.
* * *
The Committee respectfully requests that the Commission revise its proposal in accordance with the comments set forth above. Members of the Committee are prepared to meet and discuss these matters with the Commission and the staff and to respond to any questions.
1 * References to "we" and "our" mean the Committee.