The Ethics Officer as Agent of the Board:
Leveraging Ethical Governance Capability
In the Post-Enron Corporation
W. MICHAEL HOFFMAN AND MARK ROWE
Congressional, regulatory and judicial investigations into various corporate
scandals over the last five years have concluded that inadequate ethical oversight of senior
management by the board of directors has been a significant or even dominant cause. 1 The
news media may have focused on the wrongdoing of high-powered, Machiavellian
executives, driven by greed and hubris, but in any corporation the board of directors, as the
ultimate governing authority, must ensure that it discharges its fiduciary oversight function
with diligence and rigor and an independent spirit of inquiry into the activities and
proposals of the senior management team.
To be sure, there have been some egregious failures on the part of boards of major
corporations. Boards have, for instance, been found to have: Consistently ceded power
over the direction of the Company to the CEO (WorldCom) 2; knowingly allowed the
company to engage in high-risk accounting practices (Enron) 3; witnessed numerous
indications of questionable practices by management over several years, but chose to
ignore them to the detriment of shareholders, employees and business associates (Enron) 4;
known of violations of law, taken no steps in an effort to prevent or remedy the situation,
W. Michael Hoffman is the founding Executive Director of the Center for Business Ethics and the Hieken
Professor of Business and Professional Ethics at Bentley College, as well as the senior partner of Hoffman
Rowe, a Boston-based business ethics and corporate responsibility consulting firm.
Mark Rowe is the Senior Research Fellow at the Center for Business Ethics at Bentley College and the
managing partner of Hoffman Rowe.
and failed to act for a long period of time, resulting in corporate losses (Abbott
Laboratories) 5; failed to be sufficiently informed and to act independently of the chairman
of the board (Fannie Mae) 6; routinely relied on management and the external auditor’s
representations with little or no effort to verify the information provided (Enron) 7; and
failed to function in a way that made it likely that they would notice red flags
(WorldCom) 8.
The ingenuity, sophistication and complexity of some of the frauds perpetrated by
company executives do not in any way excuse or mitigate the failure of boards to
intervene. On the contrary, such cases tell us that the relevant boards were deficient in
significant respects. The various examples we cite have in common a board approach that
defaulted to passivity, acquiescence and sometimes even indifference. Worse still, in some
cases, there was knowledge and collusion of the board in the misdeeds of management.
All the while, fiduciary responsibilities to shareholders demanded that directors should
have acted in a spirit of independent and rigorous inquiry, insisted on full and complete
information, challenged management when necessary and taken decisive action when
appropriate. Investigators and commentators have pointed to boards rife with conflicts of
interest and lulled by complacency; directors who were inadequately qualified, prepared or
equipped for the rigors of their role; and boards that simply did not exert the requisite
authority.
There is an additional factor in these governance failures, which so far appears to
have received almost no attention: the ethics and compliance function in corporations has
not been working in the way it should, with an all-too-frequent disconnection from the
board. More specifically, ethics officers and the programs they oversee have not engaged
boards of directors fully and meaningfully to provide the degree of ethical oversight
2
necessary to ensure truly effective corporate governance. There are at least three reasons
for this. First, to put it bluntly, ethics officers are in thrall to senior management — the
fact that they are typically appointed by, report to, have their compensation set by, and are
capable of being fired by senior management, creates an inherent conflict of interest.
Secondly, in most cases ethics officers do not have the power, status and authority in their
corporations that they need to do their job effectively.
Thirdly, the nature of the
relationship, as presently structured, between ethics officers and their boards does not
engender effective and authoritative collaboration, thereby hampering not only the ethics
and compliance program but also the governance process as a whole.
Before examining these issues in detail, we need to acknowledge that considerable
efforts have been made to promote corporate governance reform; almost all legislation and
new regulations to that end have in some way increased the responsibilities of the board.
The provisions of the Sarbanes-Oxley Act of 2002 (“SOX”), which increase board
audit committees’ responsibilities for the oversight of public company financial reporting
and auditing, come immediately to mind. Also notable are the references in SOX to
director involvement in aspects of corporate compliance and ethics programs.
For
example, in April 2003, the U.S. Securities and Exchange Commission (“SEC”) adopted a
rule, pursuant to section 301 of SOX directing the national securities exchanges to prohibit
the listing of securities of any company whose audit committee has not established
procedures for the receipt, retention and treatment of complaints received by the company
in connection with accounting, internal accounting controls, or auditing matters, and the
confidential, anonymous submission by employees of concerns regarding questionable
accounting or auditing matters. 9
3
The United States Sentencing Commission’s 2004 amendments of the Federal
Sentencing Guidelines for Organizations (FSGO) also increased directors’ responsibilities
(in all companies, not simply those that are publicly traded) for the oversight of their
company’s compliance and ethics program. The amended FSGO requires that in order for
its company to have an “effective compliance and ethics program,” the board must be
knowledgeable about the content and operation of the compliance and ethics program and
must exercise reasonable oversight with respect to its implementation and effectiveness. 10
Directors are also now required to be educated about the company’s standards and
procedures through “effective training” and the dissemination of information appropriate to
their roles and responsibilities. 11 Additionally, the amended FSGO includes a new focus
on corporate culture and the role of the board of directors (and other high-level personnel)
in promoting “an organizational culture that encourages ethical conduct and a commitment
to compliance with the law.” 12
As welcome as the above governance improvements are, none of them has
effectively addressed the three inherent problems identified above. This paper will propose
that an important step in addressing those problems effectively is to make the ethics officer
an agent of the board of directors. Under this new model the ethics officer would be
appointed by the board, would report directly and be accountable to the board, and would
have his or her compensation set by the board. Furthermore, only the board would be
capable of firing the ethics officer.
Precisely how the ethics officer’s employment contract would be structured and
implemented is a matter for employment lawyers, and beyond the scope of this paper. We
are concerned with the concept of an ethics officer whose tenure is on the terms suggested
above, with particular emphasis on reporting directly to the board. When we speak in this
4
paper of reporting directly to the board, we mean a relationship of full accountability. This
is a relationship that far exceeds the giving of periodic reports to the board about what is
going on in the ethics and compliance program. The FSGO now recommends at least one
such appearance before the board annually. 13 This may give the ethics officer limited
“access” to the board but that is very different from a direct reporting relationship. In
addition, as one of the authors of this paper (Hoffman) noted in an earlier co-authored
paper, having access to the board does not necessarily enhance an ethics officer’s
independence from company management. 14
Unless otherwise indicated, the term “ethics officer” (EO) will be used throughout
this paper to signify the person with responsibility for overseeing a company’s ethics,
compliance and business conduct efforts; in other words, the chief ethics officer, whose
brief is to provide strategic and operational leadership to the ethics and compliance
program.15
We recognize that many other terms (e.g., compliance officer, business
conduct officer, and business practices officer) are in common usage 16 but use “ethics
officer” for convenience. Terminological differences aside, the ethics officer position was
created in some companies more than 20 years ago, 17 but it received a strong mandate with
the introduction of the FSGO in 1991, which required organizations to appoint a high-level
individual to oversee compliance with business conduct standards. The chief ethics officer
is usually an appointment at the vice president or senior vice president level, and this
person often has other duties to perform, which in some companies may be as general
counsel or head of human resources.
Indeed it is rare for the chief ethics officer to be
responsible for the day-to-day management of the ethics and compliance program, which
will normally be delegated to a person at the director or manager level (who, in turn, will
most likely supervise others). The authority, influence and effectiveness of the day-to-day
5
ethics officer (and his or her team) are largely derived from that of the chief ethics officer.
The latter point is important and will be addressed later in the paper.
Let us now consider in more detail the three major flaws in the structure and
operation of the ethics and compliance function and, more specifically, its relationship to
the board of directors. To a greater or lesser extent, these shortcomings are limiting the
effectiveness of the ethics and compliance function and creating obstacles to good
governance in virtually every corporation in the United States.
An Inherent Conflict of Interest in Current EO Reporting Structures
The EO is the person with primary responsibility for ensuring a company’s ethical
performance. This is now understood as being at least equally important as the company’s
financial performance because, as we have seen many times in recent years, the latter can
be derailed dramatically by ethical missteps. Such is the connection of a company’s
ethical performance to its financial stability, reputation and its risk profile generally, that
ethics and compliance is as critical a corporate function as marketing, sales, finance and
human resources. In some respects it is more critical since it touches every aspect of a
corporation’s business operations like no other corporate function, and is inextricably
connected to the organization’s governance.
When a company seeks to create and sustain an ethical organizational culture, it is
critical to promote the universal expectation that no one in the company, no matter how
senior, is above the law or the requirement to behave ethically.
Everyone from the
chairman of the board and the CEO to the most junior mailroom assistant has to be
ethically accountable. And given the importance of senior management’s performance to
the company’s success, as well as its significant influence on the corporate ethical culture,
6
one of the EO’s most important responsibilities is to monitor and critique senior
management’s decision-making and conduct.
However, when the company’s reporting structure is set up so that the EO is
appointed by, reports to and is accountable to management — the situation in almost all
companies — this creates a conflict of interest. If the EO’s job or career is dependent on
the very people whom he or she may need to call to account in respect of their own ethical
conduct, there is immediately a possibility that the EO will be influenced by personal
interest (consciously or subconsciously) and his or her objectivity or independence will be
compromised. 18 Typically, the EO will have been hired by senior management; the EO
reports to senior management, to whom he or she is accountable; his or her performance is
evaluated by senior management; the EO’s compensation is set by senior management; and
the EO can be fired by senior management, which could mean not only losing a job but
also possibly a career.
This conflict of interest can have far-reaching consequences for an organization.
Not only can this conflict interfere directly with the EO’s judgment and effectiveness in
monitoring the decisions and conduct of management, but it might also give rise to a
perception among employees generally that management is treated differently. In that
event, the EO’s credibility and that of the ethics and compliance program is at risk.
As if that were not a huge concern in and of itself, consider the need for corporate
ethics and compliance programs to have credibility with regulators, prosecutors and
sometimes, unfortunately, sentencing judges.
Self-evidently, such credibility depends
significantly upon the way in which EOs are appointed and function. Any question mark
over the independence and objectivity of the EO in a particular case is a matter for
consideration in assessing program effectiveness within the terms of both the FSGO and
7
the Department of Justice’s so-called “McNulty Memo” (and its predecessor, the
“Thompson Memo.”) 19
Lest anyone should think these concerns are academic, let us consider two recent
and stark illustrations. In 2004 Strong Capital Management (SCM),20 was subject to
administrative and cease-and-desist proceedings by the SEC. 21 The case is notable because
a compliance officer, appointed by and reporting to senior management was indicted for
not doing his job; and had he acted as he should have done he might well have been fired
by the CEO.
In 2000, Tom Hooker, SCM's Director of Compliance at the time, noted CEO
Richard Strong's frequent personal trading in a compliance review.
On hundreds of
separate occasions Strong made redemptions that were inconsistent with limitations in the
funds’ prospectuses, realizing personal profits of several million dollars. Hooker informed
SCM’s in-house counsel, who was also the Chief Compliance Officer (and Hooker’s
supervisor), of Strong's activities. In-house counsel told Strong that his frequent trading to
the detriment of the funds and their shareholders should stop immediately. In-house
counsel directed Hooker to monitor Strong's trading activity.
Although Hooker was
directed to monitor Strong's trading, he failed to follow up on this problem to ensure that
Strong's trading activity had in fact stopped. There were no compliance measures
implemented to monitor or prohibit his delinquent activities.22
Thus, even though SCM had a chief compliance officer and a director of
compliance, the compliance function was unable and/or unwilling to stop Strong’s
unethical (and often illegal) activities. It seems safe to assume that both compliance
officers were affected by the conflict of interest that arose by reason of their having been
hired by SCM’s senior management. For the record, the SEC investigation found Hooker
8
to have willfully aided and abetted and caused Strong and SCM's violations, fined him
$50,000 and barred him from working in the investment industry.
The Fannie Mae case provides a second example of a systemic conflict of interest
preventing the ethics and compliance function from doing its job. Fannie Mae is the
largest firm in the U.S. housing finance system.
It was the subject of an earnings
management scandal that led the SEC, in 2004, to direct the firm to restate its financial
results for 2002 through mid-2004, on account of a $10.6 billion income and capital
overstatement. In the report of its investigation of Fannie Mae, the Office of Federal
Housing Enterprise Oversight (OFHEO) noted that Fannie Mae’s senior management,
through their actions and inactions, committed or tolerated a wide variety of unsafe and
unsound practices and conditions between 1998 and 2004. 23
Improper earnings
management at Fannie Mae increased the annual bonuses and other compensation linked to
earnings per share that senior management received.
Fannie Mae had an Office of Corporate Compliance (OCC) which it had
established in late 2002 in order to enhance its ethics and compliance program. The OCC
was led by the Chief Compliance Officer who reported to the General Counsel.
However,
the Report to the Special Review Committee of the Board of Directors of Fannie Mae
(popularly known as the “Rudman Report,” after Warren B. Rudman, the former senator
who led the independent commission that produced it) found that Fannie Mae’s
management undermined the perceived independence and impartiality of the company’s
ethics and compliance functions by housing them within a litigation section of the Legal
Department, headed by a Chief Compliance Officer, who also served as the head of the
employment practices litigation group responsible for defending the company against
employee complaints. 24
9
This kind of reporting structure for EOs is not uncommon. At the Conference
Board’s Ethics and Compliance Conference in May 2006, Richard Bednar, Coordinator of
the Defense Industry Initiative on Business Ethics and Conduct (DII) presented the results
of an informal survey of 51 EOs in the defense industry, showing that 22 percent of them
report to the legal department.
Our concern about this reporting structure is that a
company’s General Counsel and legal department have a duty, first and foremost, to
protect the interests of the company, which includes giving advice and taking action to
prevent, defend, or prosecute legal proceedings.
This is, of course, a necessary and
legitimate pursuit. However, when one introduces oversight of the company’s compliance
and ethics program to the legal department’s area of responsibility, a significant problem
will arise sooner or later: One of the main objectives that a successful compliance and
ethics program should have is to create an organizational climate of openness and
transparency. This entails encouraging and supporting employees in voicing concerns of a
legal or ethical nature — whether to seek advice or report allegations — so that those
concerns can be addressed, to protect the rights of individuals and the ethical integrity of
the organization as a whole. However, when concerns are raised that suggest the company
may be at risk, the legal department’s primary responsibilities will require it to take a
defensive posture, most likely attaching legal professional privilege to relevant
communications, and this is fundamentally at odds with the above objective. Furthermore,
the essentially rules-based, procedural nature of legal practice is never likely to be the best
platform from which to inculcate the principles and values that are the foundations of an
ethical corporate culture. 25
Joe Murphy, a leading commentator on ethics and compliance issues, notes that the
acid test of a compliance program is whether it can stand up to powerful managers who are
10
accustomed to having things their own way. 26 We agree with Murphy that this requires the
EO (and those working for him or her) to be empowered and protected. But providing the
EO with sufficient power and protection will be problematic unless the conflict of interest
identified above is effectively removed.
In order to lead, fortify and oversee the company’s efforts to promote and engage in
ethical business practices, EOs must operate under conditions which enable them to
conduct their responsibilities independently, impartially and without fear of retribution,
whether direct and immediate or insidious and subtle over a period of time. However, it
would appear very difficult, if not impossible, to assure EOs these conditions under a
system in which they are appointed by, report to and are accountable to senior
management.
We must therefore acknowledge the possibility that EOs, in more
companies than we would care to imagine, may be subject to pressure — consciously or
subconsciously — not to report on the unethical conduct of a company officer who could
fire him or her or otherwise negatively affect his or her livelihood or work situation. This
leaves us with the choice of accepting the current system as the best we can devise, or
creating a better one. We prefer the latter option.
The proposal that the EO should be an agent of the board is perhaps somewhat
radical — and unlikely to be universally popular 27 — but, in our view, very necessary. By
fundamentally altering the nature of the EO’s relationship with the board, the conflict of
interest is removed. In this way, the EO can operate independently of management with
the direct authority of the board and all the protection that this affords.
11
Ethics Officers Do Not Have Sufficient Power, Status and Authority.
While there is no doubt that an ethics officer profession has become well
established over the last decade, 28 we believe there is a worrying recent trend towards
declining EO importance in the corporate hierarchy. Our view is supported by Bednar,
who suggests that today’s EO is a “position looking for a role” and lists a number of
telltale signs that may indicate whether the importance of ethics is cooling in an
organization. These include: the EO is not being regularly invited to attend the CEO’s
meetings with direct reports; resourcing of the ethics office is not keeping up with other
functional areas; the EO is asked to take on assignments unrelated to his/her core mission;
primary ethics functions are becoming outsourced, particularly in the areas of
hotline/helpline management and training; and the boss calls the general counsel instead of
talking to the EO. 29
If any of the above signs become apparent in an organization, the EO does not have
all the power, status and influence that he or she should have. Bear in mind that the
amended FSGO requires the person with operational responsibility for an organization’s
ethics and compliance program to be given “adequate resources” and “appropriate
authority.”30
Murphy emphasizes that any company seriously committed to compliance and
ethics should ensure that its compliance officer and staff are empowered. He argues that
this is indispensable for the compliance program itself to be effective. He notes that one
fundamental step in the direction of giving the EO the power and authority he or she needs
— and showing full commitment to the success of the ethics and compliance program — is
to have a strong board of directors’ resolution endorsing the program. A good resolution
will commit the company at the highest level and fully empower the EO. 31 We agree with
12
Murphy that it is necessary to empower the EO and his/her program. However, a board
resolution is a necessary but insufficient means to achieve this. Our solution goes much
further than this.
The proposal that the EO be an agent of the board has the important virtue of
elevating the EO in the corporate hierarchy. It would also give the EO the very real
authority that comes with any board appointment, and would signal to management and all
employees, more than any board resolution, that the ethics and compliance program was
endorsed and supported by the highest authority in the corporation.
Boards Need to Enhance Their Ethical Oversight Capabilities
We observed at the beginning of this paper that most, if not all, of the corporate
ethical scandals of recent years can be characterized as failures of governance. One of the
most significant problems has been that boards of directors have not adequately fulfilled
their ethical oversight responsibilities in respect of senior management and the company as
a whole. In some cases, boards were not sufficiently engaged or, worse still, they were
negligent. In others, they were not well enough informed or equipped to do what was
required of them.
To be sure, all boards need to motivate and equip themselves to pursue their
responsibilities with an emphasis on active, informed and independent inquiry. They
require the knowledge, skills, tools and support that will allow them to exercise the
necessary oversight over senior management and to actively promote an ethical corporate
culture.
It is not enough for directors to be diligent and vigilant; they need to assure
themselves access, on demand, to high quality information about management proposals
13
and activities, and about the company’s operations in general. Ideally, the board will
acquire such information in the ordinary course of an open and collaborative relationship
with senior management. However, we have seen from recent history that boards cannot
depend on management disclosure and must take a proactive approach to information
gathering and processing.
It is critical that the board receives a continuous and uncorrupted flow of
information about matters critical to its oversight of the company. This information must
necessarily be accurate, up to date and unfiltered.
Failure in this process was found by
the Rudman Report to have been a key factor in what occurred at Fannie Mae.
Specifically, the Report noted that among the numerous deficiencies afflicting Fannie
Mae’s ethics and compliance program, as of late 2004, was “an unstructured information
flow to the board.” 32 While information was given to the board from time to time, it does
not appear that it was provided in ways that enabled the board to assess the effectiveness of
the company’s ethics and compliance programs.
We suspect that the Fannie Mae experience is being played out, perhaps in less
extreme but nevertheless dangerous ways, in many companies today. The Conference
Board survey mentioned earlier found that only 20 percent of responding EOs reported to
the board of directors, which is an unacceptably low proportion — regardless of how one
defines the concept of “reporting” to the board. We do not know what, if any, definition of
“reporting” was applied in the Conference Board survey, though we suspect that many of
the EOs surveyed were required to make only infrequent and brief periodic reports to their
boards. We alluded earlier to our concern about the quality and frequency of EO reports to
the board. In order to be meaningful and effective, we believe that only direct reporting to
14
the board, as we have defined it, will achieve the objective of improving governance
standards.
Some might say that the board failures we have seen at companies like Enron,
WorldCom, Tyco, Fannie Mae and other companies were isolated, albeit costly,
aberrations and that the vast majority of boards would not allow management the same
degree of latitude. The same people might argue, especially in a climate of heightened
ethical awareness and regulatory fervor, that boards are focused on their oversight
responsibilities like never before; and that directors are already doing all they can to
maximize their capabilities. The first part of the above contention may be true although we
have doubts about the second part. On this matter there is no room for complacency.
Every single board of directors in Corporate America should assess the potential for
improving ethical oversight capabilities. 33
By changing the nature of the EO’s relationship with the board of directors, not
only will the EO become more effective but he or she can also significantly assist the
board in performing its ethical oversight responsibilities; this will increase ethical
corporate governance. The EO can help and advise the board on acquiring, analyzing and
acting upon information that is pertinent to the board’s ethical oversight responsibilities.
In particular, the EO’s connection to every part of the organization, and his or her unique
perspective and technical expertise can assure the board of a much higher quality of
information than it might otherwise receive.
The EO can help the board in a number of other ways. A closer ongoing
relationship with the board will enable the EO to engage the directors in a more
comprehensive process of continuous education about ethics and compliance issues in the
company, ensuring that they are fully informed about their own responsibilities. This is
15
likely to raise the board’s general level of ethical awareness, and can help directors to
achieve greater consensus around ethical practices in the company, in its industry and
around ethical issues affecting the board itself. The EO can also provide the board with
guidance on finding opportunities to demonstrate ethical leadership and generally to
positively influence the corporate culture in the manner contemplated by the FSGO.
As well as providing the directors with an educator and discussion facilitator, an
elevated role for the EO could position him or her as “ethics counsel” to the board. Having
such guidance could be helpful not only as the board performs its oversight responsibilities
in respect of the company, but also in holding itself to required ethical standards. Perhaps
Hewlett-Packard’s board of directors might have handled its internal investigation of a
press leak with greater sensitivity if the company’s EO had been an agent of the board. We
cannot be sure how an individual in such a position would have brought about a different
outcome, though we do know that the chairwoman of the board would not then have been
able to resort to her apparent excuse that she relied on management to advise on the ethical
appropriateness of the investigative techniques used against members of the board itself
and certain journalists. 34 But this situation aside, unless the EO is made an agent of the
board of directors in the manner proposed, the board may lack information of sufficient
quality and timeliness, and may not have the full complement of tools, advice and support
it requires to perform its governance responsibilities.
Developments Supporting an EO-Board of Directors Reporting Relationship
What we are proposing in this paper may be controversial, but it is not without
precedent or analogy.
16
The United States Sentencing Commission felt sufficiently concerned about board
oversight of ethics and compliance to insert a new requirement in the FSGO in November
2004 to the effect that:
Individual(s) with operational responsibility [for the ethics and compliance
program] shall report periodically to high-level personnel and, as appropriate, to the
governing authority, or an appropriate subgroup of the governing authority, on the
effectiveness of the…program.35
Note that the above provision requires reporting to the board as appropriate. The
FSGO (and application notes thereto) are silent as to what is meant by appropriate, other
than to say that if the chief ethics officer does not have day-to-day responsibility for the
program, the person who does should report to the board “no less than annually.” One can
make a case that the chief ethics officer (briefed as necessary) should appear before the
board on a much more regular basis. In any event, we suspect that the reporting by EOs to
the board, as it is presently being handled, is not appropriate; nor indeed will it be
appropriate until there is a direct reporting relationship of the kind we are proposing.
We find further support for our argument in a (non-binding) footnote to the SEC
final rule applying to Section 406 of SOX, in which the SEC opines on what it means by
the “appropriate person” to whom violations of the code of ethics should be reported. The
relevant part of the footnote says:
…we believe the person identified in the code [as the appropriate person] should
have sufficient status within the company to engender respect for the code and the
authority to adequately deal with the persons subject to the code regardless of their
stature in the company. 36
Almost always, the “appropriate person” will be the EO since he or she typically receives
reports of code violations. Clearly, the EO must have adequate authority to deal even with
the CEO if necessary. As argued earlier, this is problematic if the EO reports to the CEO
or to someone who reports to the CEO. It is logical to extrapolate the SEC’s perspective to
17
a requirement that the EO should report directly to the board of directors along the lines we
are proposing. 37
An analogy might also be drawn from Section 301(2) of SOX, which requires the
board of directors of a public company (through its audit committee) to be directly
responsible for the appointment, compensation and oversight of the external auditors. We
are effectively proposing that the board of directors be directly responsible for the
appointment, compensation and oversight of the EO on the basis that independence and an
absence of conflicts of interest are just as essential to the successful performance of the
ethics and compliance function as to the external audit function.
Perhaps even more directly applicable is the analogy of compliance officers in the
mutual fund industry. The SEC’s Rule 38a-1 requires each mutual fund to appoint a chief
compliance officer (CCO) who must report directly to the fund’s board of directors. The
rule contains several provisions expressly designed to promote the independence of the
CCO from the management of the fund. First, only the fund board can hire or fire the
CCO. The fund board (including a majority of independent directors) must approve the
designation of the CCO and must approve his/her compensation (or any changes in his/her
compensation). The SEC’s commentary on the rule contains the following interesting
observation that is germane to the issues we are considering:
We have observed that executives at service providers have overruled their own
compliance personnel because of business considerations. For example, some fund
advisers have continued to permit investors with whom they had other business
relationships to engage in harmful market timing in fund shares after compliance
personnel and portfolio managers brought the market timing activity to their
attention. These compliance personnel may not have had access to fund directors
or, having been overruled by their own management, may have felt they were not in
a position to approach the board. 38
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Anticipated Objections and Rebuttals
On the basis of interviews with a number of current or retired EOs, 39 and on the
basis of informal conversations with EOs, we expect opposition to our proposal that the
EO should be an agent of the board. Let us consider a sample of these objections and
counter each in turn.
Our CEO/senior management team is highly ethical; so perhaps it is important for some
companies to have an EO who is an agent of the board, but it’s unnecessary for ours.
This position is optimistic at best, certainly naïve, and betrays a dangerous
complacency of the kind that almost certainly foreshadowed the ethical eclipses at the
various corporations mentioned earlier. It takes no account of the fact that even managers
with a longstanding reputation for integrity can, and sometimes do, buckle under
extraordinary pressure, allowing their ethical judgment to be compromised by what they
see as overriding business considerations. Furthermore, the management of a company is
likely to change at some point. New executives’ ethical credibility will remain unproven
unless and until they are tested by an ethical dilemma — and each subsequent ethical
dilemma after that.
It is impractical for the EO to report directly to the board of directors (as opposed to
management) because the board comprises outsiders who meet infrequently, and who
therefore are out of touch with the company’s operations.
This argument reflects a limited view of how a board ought to work — and ignores
what is happening with a lot of boards. For one thing, directors are frequently engaged in
company business outside of official meetings and throughout the year, as individuals and
in board committees. The argument also ignores the fact that the EO’s access to the board,
even as presently constituted, is not (and should not be) limited to formal meetings, and
many EOs currently develop relationships with individual directors. If, in fact, the board is
19
out of touch with happenings at the company, how could a direct reporting relationship
between the EO and the board do anything but help the situation?
Management would view the EO as an outsider and would not take him/her seriously.
There is today no shortage of evidence (anecdotal and reported by the press) of
“insider” EOs being excluded or marginalized by management. We actually believe that
an EO who is an agent of the board of directors has more, rather than less, chance of being
taken seriously by management. Management ought to be looking to build a collaborative
relationship with the board, and if they feel threatened or uncomfortable in giving full
disclosure to one of its agents, it is a sign that something is wrong in the organization.
Management would not share information with the ethics officer if he or she were not a
part of management.
This position assumes that under the current reporting model, management always
shares information with the EO. That is certainly not always the case, as we know from
anecdotal evidence, from media reports and deposition evidence in legal cases. As agent
of the board, we contend that such information sharing with the EO would increase.
The proposal, if implemented, would damage the EO’s relationship with management and
would preclude a collaborative relationship between the parties.
If the EO were an agent of the board, this need not alienate the EO from senior
management; in fact, when implemented appropriately it would enable the EO to serve as
an important conduit between management and the board. Some might say this betrays a
naïve impression of human nature and corporate realities. We would simply counter that if
management is operating in the right way for the right reasons they have nothing to hide
from the board; indeed management should actively cultivate open channels of
communication.
At the same time it is essential for everyone in the company to
understand the importance of the EO’s role and be clear that his or her ultimate loyalty and
20
responsibilities are to the board and those whose interests it represents, the shareholders
and other stakeholders.
The proposal would cast the EO in the role of the “ethics police,” which is an undesirable
perception that will hamper the EO’s effectiveness.
Our response to this objection is simply to say that it departs from the current
reality. If the EO is not in some fashion operating as the “ethics police” we wonder why
he or she is in the job at all. Call it oversight or policing or what you will, but this is a
critical part of the ethics and compliance function. In saying this, we do not wish to
underplay another function of the EO: adding value to a corporation by helping to create an
environment of trust and cooperation. This is an enterprise in which the board of directors
needs to be fully invested and we believe our proposal assists in facilitating this.
The point about an inherent conflict of interest applies not only to EOs but also to internal
auditors, lawyers and accountants. People in these functional areas can have selfinterested reasons to manipulate the truth and not report wrongdoing.
The functional responsibilities of professionals in other areas may include, but are
not primarily dedicated to, the assurance of the ethical health and integrity of the
organization. For the EO, however, this is precisely the primary mission, which makes it
especially important that management not apply undue pressure.
Furthermore, we
recommend that the EO collaborate with other functional areas to help ensure that they
perform their ethical responsibilities.
Conclusion
Even though the corporate scandals of the last five years have had myriad complex
causes and repercussions, to a greater or lesser extent all of them involved fundamental
failures of governance. Checks and balances that should have ensured proper oversight of
management, triggering corrective action when necessary, were either deficient or absent;
21
systemic conflicts of interest were tolerated, even encouraged; and cultural influences that
minimized or eliminated ethical concerns were allowed to fester. In some cases, boards of
directors were simply not exhibiting the kind of authority, independence or rigor demanded
by their fiduciary responsibilities as the ultimate guardians of the shareholders’ and other
stakeholders’ interests. In spite of an unprecedented legislative and regulatory response to
these events in the United States, resulting in the biggest overhaul of corporate governance
for 70 years, we believe that an underlying cause of governance failures in corporations
has been overlooked: a systemic disconnectedness of the ethics and compliance function
from the board of directors, which has prevented both from working as they should. This
paper has identified three aspects of this malaise. First, there is an inherent conflict of
interest in having EOs as a part of management because of the lack of independence and
susceptibility to undue pressure that this reporting structure creates. Secondly, EOs often
lack the power and authority to curb misguided or malevolent executive behavior. Thirdly,
the current reporting structure precludes the degree of collaboration between the EO and
the board that we believe is necessary for fully effective ethical governance.
Having the EO appointed as agent of the board will effectively deal with these
problems, providing further leverage for corporate governance reform and society’s pursuit
of increasingly ethical corporate cultures.
This recommendation not only carries the
mandates of the FSGO and SOX to their logical conclusions but also is foreshadowed by
developments in the accounting and mutual fund industries.
The question arises as to how our proposal might take effect. Boards of directors
and stakeholders might appreciate its potential for enhancing governance capabilities, but
board resolutions to change the EO reporting structure would almost certainly face
obstructions in implementation. We have acknowledged that the proposal is unlikely to be
22
popular with companies’ senior management or even many EOs — though it seems to us
that popularity is rarely the best indicator of merit. While it would be preferable for
companies to voluntarily take the steps we are proposing, thereby signaling a strong
commitment to truly effective ethical governance, we suspect a legislative or regulatory
intervention will be necessary to install EOs as agents of the board.
NOTES
1
See, for example, “The Role of the Board of Directors in Enron’s Collapse,” Report of the Permanent
Subcommittee on Investigations of the Committee of Governmental Affairs, United States Senate, dated July
8, 2002. (Available online at: http://fl1.findlaw.com/news.findlaw.com/cnn/docs/enron/senpsi70802rpt.pdf);
see also Richard C. Breeden, “Restoring Trust: Report to The Hon. Jed S. Rakoff, The United States District
Court for the Southern District of New York, on Corporate Governance For The Future of MCI, Inc.,” dated
August 2003.
(Available online at: http://fl1.findlaw.com/news.findlaw.com/hdocs/docs/worldcom/corpgov82603rpt.pdf)
2
“Restoring Trust,” 1.
3
“The Role of the Board of Directors in Enron’s Collapse,” 3.
4
Ibid.
5
In re: Abbott Laboratories Derivative Shareholders Litigation 325 F.3d 795 (7th Cir. 2003).
6
“Report of the Special Examination of Fannie Mae” by the Office of Federal Housing Enterprise Oversight
(OFHEO), dated May 2006.
(Available online: http://www.ofheo.gov/media/pdf/FNMSPECIALEXAM.PDF.)
7
“The Role of the Board of Directors in Enron’s Collapse,” 14.
8
“Report of the Special Investigative Committee of the Board of Directors of WorldCom, Inc.,” dated March
31, 2003.
(Available online: http://fl1.findlaw.com/news.findlaw.com/hdocs/docs/worldcom/bdspcomm60903rpt.pdf.)
9
Standards Relating to Listed Company Audit Committees, Exchange Act Release Nos. 33-8220, 34-47654,
17 C.F.R. §§ 228, 229, 240, 249, and 274 (April 25, 2003)
10
United States Sentencing Guidelines Manual § 8B2.1(b)(2)(A).
11
United States Sentencing Guidelines Manual § 8B2.1(b)(4).
12
United States Sentencing Guidelines Manual § 8B2.1(a)(2).
13
The Application Notes for §8B2.1(b)(2) of the Federal Sentencing Guidelines for Organizations state: “If
the specific individual(s) assigned overall responsibility for the compliance and ethics program does not have
day-to-day operational responsibility for the program, then the individual(s) with day-to-day operational
responsibility typically should, no less than annually, give the governing authority or an appropriate
subgroup thereof information on the implementation and effectiveness of the compliance and ethics
program.”
14
W. Michael Hoffman, John D. Neill and O. Scott Stovall, “An Investigation of Ethics Officer
Independence.” Paper presented at the 12th Annual International Conference Promoting Business Ethics on
October 26, 2005, in New York City, NY. (This paper has been accepted for publication in a forthcoming
issue of the Journal of Business Ethics.)
15
The Ethics & Compliance Officer Association, the leading membership organization for individuals with
ethics, compliance and business conduct responsibilities, defines an Ethics & Compliance Officer as being
23
“tasked with integrating their organization's ethics and values initiatives, compliance activities, and business
conduct practices into the decision-making processes at all levels of the organization.”
(See www.theecoa.org.)
16
For a detailed review of terms in use see James F. Weber and Dana Fortun, "Ethics and Compliance
Officer Profile: Survey, Comparison, and Recommendations.” Business and Society Review, 110 (2005): 97115.
17
In particular, the defense industry fraud, waste and abuse scandals of the mid-1980s, leading to the Defense
Industry Initiative of 1986, were responsible for a flurry of ethics- and compliance-related appointments.
18
See Hoffman, Neill and Stovall.
19
Memorandum, dated December 12, 2006, from Deputy Attorney General of the United States, Paul
McNulty, to United States Attorneys, giving updated guidelines for prosecuting corporations. It includes nine
factors to consider when weighing whether to charge or negotiate a plea in corporate criminal cases: (1)
Nature and seriousness of the offense; (2) Pervasiveness of wrongdoing in the corporation, including
management complicity; (3) History of prior conduct; (4) Corporation’s timely and voluntary disclosure of
wrongdoing, and willingness to cooperate; (5) Existence and adequacy of pre-existing compliance program;
(6) Corporation’s remedial actions; (7) Collateral consequences; (8) Adequacy of prosecution of individuals
responsible for corporation’s malfeasance; and (9) Adequacy of civil and regulatory remedies. The McNulty
Memorandum replaced the Thompson Memorandum of 2003.
For more information see:
http://www.usdoj.gov/dag/speech/2006/mcnulty_memo.pdf
20
Strong Capital Management was a registered investment adviser to the Strong Funds Complex, a family of
mutual funds.
21
In the Matter of Strong Capital Management, Inc., Strong Investor Services, Inc., Strong Investments, Inc.,
Richard S. Strong, Thomas A. Hooker, Jr. and Anthony J. D'Amato.
(See http://www.sec.gov/litigation/admin/34-49741.htm.)
22
Ibid., Order, paragraphs 30-32.
23
Report of the Special Examination of Fannie Mae, 1.
24
Report to the Special Review Committee of the Board of Directors of Fannie Mae (Executive Summary),
February 23, 2006, 25.
25
The fact that nearly one-quarter of ethics officers surveyed by the Conference Board report to the legal
department is a “most disturbing trend,” according to Bednar. He observes that “ethical decisions [are] being
transferred into legal decisions…It’s the duty of the CEO’s lawyer to protect, defend, and deny — and not
engage in the root cause of the problem.” For a detailed summary of the panel discussion in which Bednar
participated, see E. L. Sherwood, “The Evolving Position of Ethics Officer,” Ethikos and Corporate Conduct
Quarterly, Vol. 20, No. 1 (2006): 10-19.
26
Joseph Murphy, “Protections for Compliance People,” Ethikos and Corporate Conduct Quarterly, Vol. 19,
No. 4 (2006): 1-19.
27
Hoffman, Neill and Stovall’s research included interviews with practicing or retired EOs, the majority of
whom felt that reporting to upper management was preferable to reporting directly to the board of directors.
28
This is evidenced by the growth in membership of the two leading professional associations for ethics and
compliance practitioners, the Ethics & Compliance Officers Association (over 1,000 members and the
Society of Corporate Compliance and Ethics (nearly 600 members).
29
For a fuller consideration of Bednar’s ideas, see Sherwood.
30
Federal Sentencing Guidelines for Organizations, §8B2.1(b)(2)(C).
31
Murphy.
32
Report to the Special Review Committee of the Board of Directors of Fannie Mae, 499.
33
The board of directors is the last resort, internally at least, for ensuring a company’s ethical standards are
upheld. Although hopefully a rare occurrence, we recognize the fact that a board of directors could act in
ethically wrongheaded ways, even to the extent of colluding with management in the pursuit of questionable
aims. In those circumstances, we acknowledge that even an EO who is appointed by, reports directly to, and
is answerable to the board, may not be able to keep the company on an ethical course. This is clearly a
somewhat extreme situation and is likely to require the intervention of some external agent; perhaps outside
regulatory authorities alerted by a whistleblower, or a shareholder suit against management and the board.
34
See “Intrigue in High Places,” Newsweek, September 6, 2006
(Available online at http://www.msnbc.msn.com/id/14687677/site/newsweek/.)
See also “Ex-H.P. Officer to Say She Knew of No Illegality,” The New York Times, September 28, 2006.
35
Federal Sentencing Guidelines for Organizations, §8B2.1(b)(2)(C).
24
36
Federal Register, Volume 68, No. 21, (January 31, 2003), page 5118, footnote 45.
For a more detailed analysis of this point see James M. Brennan, “The Future: More Ethics Officers
Reporting to the Board?” Ethikos and Corporate Conduct Quarterly, Vol. 17, No. 3 (2003): 6-8.
38
Final Rule: Compliance Programs of Investment Companies and Investment Advisers, Securities and
Exchange Commission, 17 CFR Parts 270 and 275 [Release Nos. IA-2204; IC-26299; File No. S7-03-03].
39
See endnote 24.
37
25