By H. Stephen Grace, Jr. and John E. Haupert

The Sarbanes-Oxley Act of 2002 mandates new and improved governance infrastructure and controls to improve the accuracy and reliability of corporate financial reporting. The Act focuses on public accounting oversight, auditor independence, corporate responsibility, and analysts’ conflicts of interest. The SEC is to improve its monitoring and stiffen its penalties. The section titled “code of ethics for senior financial officers” is somewhat ambivalent, and therefore should be explored by those potentially affected by it. It is a brief section and on the surface seems tame, but it may prove to be problematic to implement. There are four short paragraphs in the code of ethics section, each requiring deft handling to ensure that the final product is more than a maze of language that will have no impact on corporate governance. With only 180 days to produce the final rules to implement this section, it is possible that the resulting product may not be a control mechanism to ensure ethical performance.

The heart of the code of ethics section is a brief paragraph that defines the term “code of ethics” as the standards necessary to promote the following:

Translating such lofty goals into specific rules and instructions useful to companies will require consideration of many questions and issues. One of the most fundamental issues concerns the effectiveness of a code of ethics.

Historical Effectiveness

In addressing the effectiveness of codes of ethics, it is interesting to note the parallel between the description in Sarbanes’ section 4.06 with Financial Executives International’s (FEI) code of ethics. The first three points set out in FEI’s code are almost identical to the wording in section 4.06:

FEI’s code of ethics represents an evolution of thoughts and input from their membership and leadership over 70 years. FEI was formed in 1931 as the Controllers Institute of America (CIA); the name Financial Executives Institute was adopted in 1962 and modified to Financial Executives International in 2001. The CIA was formed to address a need for quality of thought in management. In June 1933, CIA set out 17 duties of a corporate controller, and these remained in effect until 1949, when the Institute’s Board of Directors approved four groupings of 18 duties and responsibilities. In 1962, when the organization broadened its scope to include the treasury function, a similar seven-point statement was developed to address it. Modifications continued through the years, and the current FEI code is a result of a study by the ethics and eligibility committee undertaken in 2001 and 2002, and subsequently approved by the executive committee and the national leadership board in early 2002.

The evolution of FEI’s codes of ethics leaves no doubt that the time and effort devoted to the development of these codes, and the subsequent publicity given to them, have aided financial executives to better understand their responsibilities. It is clear that an organization’s members must be held accountable for addressing the responsibilities set out in the code.

It is equally clear that problems such as those which have made headlines recently have continued to occur. The work expended by FEI’s members and the fact that the breakdowns have continued to occur make it clear that there are problems ensuring that codes of ethics will be followed. These problems are not restricted to the domain of business.

The most fundamental challenge to ensuring that codes of ethics are followed is human behavior. The history of political governance is one of monarchies and dictatorships, which political theorists have demonstrated are potentially the most efficient and effective forms of government. But monarchies and dictatorships are largely recognized as failed forms of political governance, because such all-powerful leaders fail to follow the code of ethics expected of them. While seemingly hindered by onerous, time-consuming checks and balances, democracy makes leaders accountable and has proved to be the most effective form of governance to date.

To be effective, the code of ethics for senior financial executives must be supported by a properly operating corporate governance process: a set of checks and balances involving the key players. These individuals, in their roles as members of the board, board committees, senior management, the internal or external audit function, and other involved parties, must understand their responsibilities, be accountable for them, and possess an attitude of service.

A properly functioning governance process must provide the framework for supporting the code of ethics for senior financial executives. A board whose directors understand, approve, and monitor the firm’s business activities will have processes and procedures in place to support the senior financial executives. The interaction between all of the key players of the governance process will make the observance and enforcement of the code of ethics a natural, daily occurrence rather than a specialized event. The effective corporate governance process provides a continuing opportunity for key staff within the organization to address areas of concern before they take on catastrophic proportions. An effective system of checks and balances creates a natural forum for raising issues and concerns as they occur.

Individual Differences

The second fundamental issue concerns the development of an appropriate code of ethics for each company. The individual most clearly targeted is the CFO. There are vast differences in the CFO’s responsibilities depending upon the company. In some large organizations, the CFO is equivalent to a COO, managing many aspects of a company’s day-to-day businesses, both financial and nonfinancial. In other companies, a CFO is limited to financial matters, but these encompass a wide scope, including debt issuance, insurance, risk management, hedging, investing, and pension management, in addition to all of the traditional accounting and reporting functions. The CFO in a small company might be nothing more than a chief accountant with limited accounting duties. The legislation does not give much guidance on this point, so it will be up to each company to decide what shape its code takes. The scope of responsibility must set the parameters for ethical performance. Much more explicit direction will be necessary for a CFO who is more than just the chief accountant.

Ethical behavior can be very difficult to define. A CFO’s access to information, relationships with external and internal auditors, and access to the board must all be taken into account. These factors have an impact on how much can be expected from the CFO when ethical problems surface. It would be foolish to draft a code of ethics mandating certain actions if the CFO doesn’t have the information, support, and access to react to and correct problems.

There are many issues that should be considered, and many apply to senior financial persons as well as the CFO. The legislation doesn’t make it clear who is to be covered by the code of ethics, although a provision requires each issuer “to disclose whether or not… such issuer has adopted a code of ethics for senior financial officers, applicable to its principal financial officer and comptroller or principal accounting officer or persons performing similar functions.” In some companies it might be appropriate to extend the code of ethics to the treasurer, the chief of internal audit, or the budget officer. The final rules should make it clear who is covered by this code of ethics requirement and who is excluded.

Questions arise all the time as to who senior financial officers serve. The obvious answer is the stockholders, the board, the CEO, the immediate supervisor, and the general public, but often there are conflicting interests to be sorted out. Given the circumstances, it may be difficult to uphold the code of ethics without retribution. It is important to consider penalties and protections covered by the code of ethics. This new requirement must be able to deal with those companies and individuals that violate either the letter or the spirit of the new code. Those whistleblowers who follow the code to their personal detriment must be protected from retribution and perhaps even be rewarded for their ethical performance.

Given the complexity of developing a code of ethics that addresses the many issues and differences in various companies, it makes sense to leave it to each company to write its own. The Act does not seem to require a review of the adequacy of the code by the SEC or any objective party. Will this be enough to rein in unethical behavior? There have been enough bad experiences in the past years to demonstrate that greed is a powerful motivator. Despite all of the safeguards that were intended to protect the U.S. capital markets, thousands of investors have lost billions to unethical corporate managers. The capital markets are still reeling from these actions. For them to regain positive momentum, the new code of ethics requirement must be one that helps rather than hinders.