Disclosure of Codes of Ethics for Senior Officers

By Edward S. Best, James B. Carlson, Robert E. Curley, Scott J. Davis, Jeffrey I. Gordon, Robert A. Helman, Michael L. Hermsen, James J. Junewicz, Philip J. Niehoff, Elizabeth Raymond, Laura D. Richman, David A. Schuette, Frederick B. Thomas, Mark R. Uhrynuk and James R. Walther

Section 406 of the Sarbanes-Oxley Act of 2002 ("Sarbanes-Oxley") directed the Securities and Exchange Commission (the "SEC") to adopt rules requiring companies to disclose whether they have a code of ethics for their senior financial officers, and if not, the reasons why they do not. Section 406 of Sarbanes-Oxley also required the SEC rules to mandate that issuers disclose any changes to, or waivers of any provision of, such code. The SEC issued its final Section 406 disclosure rules in Release Nos. 33-8177, 34-47235 (January 23, 2003) (the "Release") to implement these provisions, with compliance required in annual reports for fiscal years ending on or after July 15, 2003. The new rules apply to companies that are subject to the reporting requirements of Sections 13(a) or 15(d) of the Securities Exchange Act of 1934 (the "Exchange Act").

The new SEC rules have expanded the code of ethics disclosure requirements of Section 406 of Sarbanes-Oxley by requiring disclosure of whether a company has a code of ethics covering the company's chief executive officer in addition to its senior financial officers. Pursuant to new Section 406 of Regulation S-K, a company must disclose whether it has a code of ethics that applies to the company's principal executive officer, the principal financial officer, the principal accounting officer or controller, or persons performing similar functions.

In its final rule, the SEC has defined a code of ethics as written standards that are reasonably designed to deter wrongdoing and to promote:

• Honest and ethical conduct, including the ethical handling of actual or apparent conflicts of interest between personal and professional relationships;

• Full, fair, accurate, timely, and understandable disclosure in reports and documents that a company files with, or submits to, the SEC and as well as in other public communications made by the company;

• Compliance with applicable governmental laws, rules and regulations;

• The prompt internal reporting, to an appropriate person or persons identified in the code, of violations of the code; and

• Accountability for adherence to the code.

The SEC's definition of code of ethics is broader than required by Section 406 of Sarbanes-Oxley, but it is not a comprehensive list of topics appropriate to be covered by a code of ethics. The SEC believes that ethics codes should vary from company to company and that decisions as to the specific provisions of the code, compliance procedures and disciplinary measures for ethical breaches are best left to each company. The SEC strongly encourages companies to adopt codes containing provisions that are broader and more comprehensive than the minimum necessary to meet the new disclosure requirements.

The new SEC rules do not specify the procedures that companies should develop, or the types of sanctions that companies should impose, to ensure compliance with their codes of ethics. For example, the SEC does not define the characteristics of a person appropriate to receive reports of code of ethics violations (other than to mention in a footnote that the identified person should have sufficient status to engender respect and should not be involved in the matter giving rise to a violation). Selection of the appropriate individual is left to the discretion of the company when implementing its code of ethics.

The SEC's new rules provide companies with three alternatives for disclosing the text of their codes of ethics:

• a company may file a copy of its code of ethics as an exhibit to its annual report filed on Form 10-K, 10-KSB, 20-F or 40-F;

• a company may post the text of its code of ethics, or the relevant portions thereof, on its Internet website (if the company has multiple websites, the posting must be on the website normally used for investor relations); or

• a company may provide an undertaking in its annual report filed with the SEC to provide a copy of its code of ethics to any person without charge upon request.

If a company chooses website posting of the text of its code of ethics, it must disclose both its Internet address and its intention to provide disclosure of its code of ethics in the future in this manner in the annual report it files with the SEC.

The instructions to new Section 406 of Regulation S-K acknowledge that a company may have separate codes of ethics for different types of officers. This instruction also clarifies that the provisions of the company's code of ethics that are responsive to the elements listed in the SEC's definition of code of ethics and that are applicable to the specified senior officers may be part of a broader code of ethics. A company only needs to file, post or provide the portions of the code of ethics that constitute the code of ethics as defined for the purposes of new Section 406 of Regulation S-K and that apply to the persons specified by the rule. In other words, if the code of ethics for SEC disclosure purposes is part of a more comprehensive document that covers a wider range of issues or that applies to a larger group of individuals, only those portions of the code that are relevant for the new rule must be made publicly available.

In accordance with the directive of Section 406 of Sarbanes-Oxley, the SEC has added a new Item 10 to Form 8-K to require reporting waivers of, and changes to, codes of ethics. Domestic issuers will be required to disclose:

• The nature of any amendment to the company's code of ethics that applies to its principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions; and

• The nature of any waiver, including an implicit waiver, from a provision of the code of ethics granted by the company to one of these specified officers, the name of the person to whom the company granted the waiver and the date of the waiver.

The SEC has provided two alternatives for providing this disclosure. The required disclosure of amendments to, or waivers of, the code of ethics may be made on Form 8-K filed within five business days after the amendment or waiver. Alternatively, a company may use its Internet website as a means to disclose amendments to, or waivers of, its code of ethics, but only if the company has disclosed in its most recently filed annual report on Form 10-K or 10-KSB:

• its intention to disclose these events on its Internet website in the future, and

• its Internet website address.

Internet disclosure of amendments or waivers must be made in the same five business day time frame as a Form 8-K filing. Also, website disclosures must be maintained for at least 12 months and a hard copy must be maintained by the company for at least five years.

It is important to recognize that "implicit waivers" of the code of ethics must be disclosed under the new rules as well as waivers that have been actively granted. Instruction 2 to new Item 10 of Form 8-K defines the term "waiver" as the approval by the company of a material departure from a provision of the code of ethics. This instruction defines the term "implicit waiver" as the company's failure to take action within a reasonable period of time regarding a material departure from a provision of the code of ethics that has been made known to an executive officer. In other words, inaction with respect to a code of ethics violation by the senior officers identified in the new SEC rules can result in disclosure obligations. Accordingly, codes of ethics should make clear that material departures from their provisions must be promptly reported.

Under the SEC's new rules, only amendments or waivers relating to the elements of the codes of ethics specified in the SEC's definition and to the specified officers must be disclosed. This clarification is intended to facilitate the use of broad based codes of ethics. For example, an amendment to a code of ethics affecting only directors, or only officers other than the principal executive officer and the specified senior financial officers, would not require disclosure.

The SEC's code of ethics rule applies to foreign private issuers as well as to domestic issuers. Foreign private issuers will have to provide the new code of ethics disclosure in their Exchange Act annual reports. However, because the SEC does not require specific interim or current disclosure requirements for foreign private issuers, the SEC is not requiring foreign private issuers to provide immediate disclosure of any change to, or waiver of, the code of ethics applicable to their senior financial officers and principal executive officers. Instead, foreign private issuers may disclose any such change or waiver that occurred during the past fiscal year in their Exchange Act annual reports filed after their first annual report in which code of ethics disclosure was required. The SEC has revised Forms 20-F and 40-F, however, to state that a foreign private issuer may disclose any change to or waiver from the code of ethics obligations of its senior officers earlier on a Form 6-K or its Internet website. While the SEC did not mandate interim reporting of amendments or waivers of foreign private issuer codes of ethics, the SEC strongly encouraged foreign private issuers to use these alternative means of disclosure in the interest of promptness.

The SEC excluded asset backed issuers from the codes of ethics disclosure requirements.

Companies must comply with the code of ethics disclosure requirements in their annual reports for fiscal years ending on or after July 15, 2003. Correspondingly, they must comply with the requirements regarding disclosure of amendments to, and waivers from, their codes of ethics on or after the date on which they file their first annual report in which code of ethics disclosure was required.

Prior to the compliance date of the new rules, companies should carefully consider, among other things, whether they want a separate code of ethics for the senior officers identified in Section 406 of Regulation S-K or whether they want to have a comprehensive code of ethics that applies to all, or at least a larger group of, individuals within the organization. If they choose to adopt a code that applies beyond the senior group, companies must decide whether they want to identify a core portion as the code of ethics that will fulfill the disclosure requirements of the new rule, with only that portion being made publicly available. It is important to remember that only the provisions that a company identifies as the provisions constituting the code of ethics for a company's principal executive officer and other senior financial officers willrequire disclosure in the event that they are waived, either overtly or implicitly. And, once annual reports for fiscal years ending on or after July 15, 2003 become due, amendments to such codes of ethics will trigger disclosure requirements.

The Release acknowledged in a footnote, but did not discuss, the NYSE's corporate governance proposal which has a listing standard with substantive provisions relevant to codes of business conduct and ethics. The SEC has not yet even proposed for comment new listing standards which have been submitted to it. The NYSE's proposed listing standard for codes of business conduct and ethics covers a wider group of individuals than is covered by the new SEC rules. The NYSE code of business conduct and ethics would apply to all directors, officers and employees. Waivers of the NYSE code of business conduct and ethics would have to be promptly disclosed for directors and executive officers. The NYSE rules also address some principles not mandated by the SEC rules. The final listing rules may impact what the companies will ultimately include in their code of ethics.

Companies may voluntarily implement their codes of ethics for senior officers well in advance of the compliance date in preparation for the upcoming disclosure. Some companies already have codes of ethics in place that will satisfy the definition of the new rule. Companies should use the time before the compliance date of the new code of ethics disclosure rule to make final decisions about the content and scope of their codes of ethics for senior officers.

There are advantages in using the website alternative to disclose the content of the code of ethics. First and foremost, placing the code of ethics on a website will make it much easier for people to locate the code. With more and more organizations rating public companies based on corporate governance matters, it makes sense from an investor relations point of view to use website disclosure for codes of ethics because it is the most accessible form of disclosure. Website disclosure is also consistent with the NYSE's proposed code of business conduct and ethics listing standard.

There are some liability issues associated with the choice of disclosing the text of a code of ethics by filing it as an exhibit to an annual report or by posting it on a website, but they are relatively minor. The SEC has stated that disclosure of the company's website address in an annual report, which is required as part of the website disclosure alternative, will not by itself cause the entire contents of the company's website to be incorporated by reference into the annual report for liability purposes. In accordance with positions the SEC has suggested in its electronic delivery releases, it may be prudent for companies choosing website disclosure to have an inactive, rather than a hyperlinked, reference to their website in their annual reports, with an express disclaimer that the contents of the website are not incorporated by reference into the annual report. Website disclosure lessens the risk of liability under Sections 18 of the Exchange Act or Section 11 of the Securities Act of 1933 which theoretically could arise if a code of ethics is filed or incorporated by reference in a registration statement. However, the additional liability risk from filing a code of ethics as an exhibit to an annual report is small.

This article is not a complete description of the Release. There are exceptions to the general rules described above, which could significantly affect their application in particular circumstances.