Public Companies Fail to Disclose Ethics Waivers

usha rodrigues

According to Usha Rodrigues from University of Georgia Law School and Mike Stegemoller from Texas Tech University – Rawls College of Business, in their paper Placebo Ethics, public companies are failing to disclose ethics waivers.

They focused on Section 406 of Sarbanes-Oxley which requires public companies to disclose when they have granted an ethics waiver to top executives. Section 406(b) states:

“The Commission shall revise its regulations concerning matters requiring prompt disclosure on Form 8-K (or any successor thereto) to require the immediate disclosure, by means of the filing of such form, dissemination by the Internet or by other electronic means, by any issuer of any change in or waiver of the code of ethics for senior financial officers.”

The regulations for Section 406 provide:

§229.406 (Item 406) Code of ethics:
(a) Disclose whether the registrant has adopted a code of ethics that applies to the registrant’s principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions. If the registrant has not adopted such a code of ethics, explain why it has not done so.

(b) For purposes of this Item 406, the term code of ethics means written standards that are reasonably designed to deter wrongdoing and to promote:

(1) Honest and ethical conduct, including the ethical handling of actual or apparent conflicts of interest between personal and professional relationships; …

Rodrigues and Stegemoller were able to take advantage of the overlap between the 406 disclosure requirements and the disclosures required by Item 404 of Regulation S-K for related party transactions with an amount in excess of $120,000. One of the challenges of determining compliance with disclosure requirements is you can’t tell if there was a need for a disclosure unless the information is disclosed. This overlap allowed them to find items in the 10-k proxy statement that should have been reported immediately under Section 406.

Their sample set was 200 public companies. From January 1, 2003 through December 31, 2007 they found only one waiver filed under Section 406 for these 200 companies. They also looked beyond their sample set and found that of the 5,000± public companies there have only been 36 waivers filed using Form 8-K.

They took the next step and looked at the 10-K filings for their sample set of companies for related party transactions. Fifteen companies failed to disclose related party transactions that should have been reported immediately under Section 406. They found lots of other disclosures that were in a gray area. (This should be no surprise to Michelle Leder at who loves finding these things.)

One theory is that the public companies prefer to dump these related party transactions into the 10-K proxy statement where there is already a flood of information rather than specifically calling out the transaction in a separate Form 8-K. (Again, Michelle Leder loves digging up this stuff.) There is a difference between immediate disclosure and eventual disclosure.

Another surprise in the paper was that most of the companies in the sample set did not prohibit related party transactions in their code of ethics. Only 30 prohibited these transactions. These omissions also would appear to be a violation of Section 406 since the regulation requires a code to deal with conflicts of interest. Personally, I don’t see how you can call something a code of ethics if it does not prohibit related party transactions.