SEC Proposes Rules on Code of Ethics

10/31/2002
Client Alert
In a continuing effort to increase investor confidence in U.S. financial markets, on October 22, 2002 the Securities and Exchange Commission (the "SEC") issued a proposed rule (the "Proposal") relating to the Code of Ethics provisions of Section 406 of the Sarbanes-Oxley Act of 2002 (the "Act"). The Proposal would require companies subject to the reporting requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, to disclose whether or not, and if not why not, they had adopted a written code of ethics for their principal financial officer, principal accounting officer or controller, or persons performing similar functions (collectively, the "senior financial officers") and its principal executive officer. In addition, the Proposal would require companies to publicly disclose whether they had made changes to, or granted a waiver from, their code of ethics and would require companies to file a copy of their code of ethics as an exhibit to their annual report filed with the SEC.

The Proposal applies not only to domestic companies, but also to foreign private issuers and registered investment companies.

Code of Ethics

The Proposal supplements the requirements of Section 406 of the Act and defines the term "code of ethics" to mean a codification of standards that is reasonably designed to deter wrongdoing and to promote[fn1]:

  • Honest and ethical conduct, including the ethical handling of actual or apparent conflicts of interest between personal and professional relationships;
  • Avoidance of conflicts of interest, including disclosure to an appropriate person or persons identified in the company's code of ethics[fn2] of any material transaction or relationship that reasonably could be expected to give rise to a conflict of interest;
  • Full, fair, accurate, timely and understandable disclosure in reports and documents that a company files with, or submits to, the SEC and 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 company's code of ethics, of violations of the code's provisions; [fn3] and ,
  • Accountability for adherence to the company's code of ethics.
In addition, the Proposal states that a company's code of ethics should include guidelines requiring the avoidance of conflicts of interest and material transactions or relationships involving potential conflicts of interest without first obtaining proper approval. The Proposal also requires a company's code of ethics to describe the company's system for the internal reporting of violations of its code of ethics and the consequences for non-adherence to the code's provisions.

The SEC indicated in the Proposal that ethics codes may vary from company to company and that decisions as to the specific code of ethics provisions, compliance procedures and disciplinary measures for ethical breaches are best left to each company to establish. If a company does not have a code of ethics, or if a company's code of ethics does not satisfy all parts of the SEC's definition of "code of ethics," the company would be required to disclose in its annual report why it does not have a code of ethics or why the terms of its code differs from the SEC's required provisions.

Disclosure Requirements

If adopted, the Proposal would require companies to disclose, pursuant to new Item 406 of Regulations S-B and S-K, Item 15(c) of Form 20-F or Instruction B.(9) of Form 40-F:

  • Whether the company has adopted a written code of ethics that applies to the company's principal executive officer and senior financial officers; and
  • If the company has not adopted a code of ethics, the reasons why it has not done so.
In order to help investors better understand the ethical principles that govern the executives of the companies in which they invest, the Proposal would require each company to file a copy of its code of ethics as an exhibit to its annual report on Form 10-K, 10-KSB, 20-F or 40-F.

NYSE and NASDAQ Proposals

The New York Stock Exchange ("NYSE") and the Nasdaq Stock Market ("NASDAQ") have submitted corporate governance rules to the SEC for approval (the "SRO Proposals"). The SRO Proposals would require a listed company to, among other things, (1) adopt[fn4] a code of conduct, which would apply to all directors, officers and employees of the listed company, (2) make the code publicly available[fn5] and (3) promptly disclose any waiver of the code granted to a director or executive officer. [fn6] In addition, the SRO Proposals would require that a listed company's code contain compliance standards and procedures that would facilitate the effective operation of the code. It is important to note that listed companies would need to comply with both the SEC's final rules and the applicable SRO Proposal.

Disclosure Regarding Changes to, or Waivers from, the Code of Ethics

Under the Proposal, a company would have to publicly disclose changes to, or the grant of a waiver from, any provision of the code of ethics that applies to its principal executive officer or senior financial officers. The disclosure must briefly describe the nature of the amendment or waiver, and in the case of a waiver, the name of the person to whom the waiver was granted and the date of the waiver. The Proposal indicates that such disclosure must be made on Form 8-K, or on the company's website, within two business days after the change was made or the waiver was granted. A company that chooses to disclose the changes or the grant of a waiver on its own website, in lieu of an 8-K filing, must disclose in its most recently filed annual report on Form 10-K or 10-KSB[fn7] that it intends to disclose these events on its website and must specify its website address. This website disclosure would be required to be made available on the company website for at least twelve months after the company initially posts the disclosure and must be retained by the company for at least five years.

Code of Ethics Disclosure Requirements for Registered Investment Companies

The Proposal would require all registered investment companies to disclose:

  • Whether each of the investment company, its investment adviser and its principal underwriter has adopted a written code of ethics that applies to the principal executive officer and senior financial officers of the investment company, its investment adviser and its principal underwriter; [fn8] and
  • If the investment company, its investment adviser, or its principal underwriter has not adopted such a code of ethics, the reasons it has not done so.
It is important to note that the code of ethics referenced in the Proposal is substantially different from the code of ethics required by Rule 17j-1 under the Investment Company Act of 1940. The SEC would permit the consolidation of the provisions of both codes into a single document, but the topics and persons covered by the Proposal's code are not the same as those covered by a Rule 17j-1 code.

If the investment company, its investment adviser, or its principal underwriter has amended or granted a waiver from any code of ethics applicable to its principal executive officer and senior financial officers, the investment company must provide a brief description of the amendment or waiver in its report on proposed Form N-CSR or Form N-SAR, as applicable. In the alternative, the investment company may choose to make such disclosure on its website, within two business days after it made the change or granted the waiver. An investment company that chooses to disclose the changes or the grant of a waiver on its own website, in lieu of an 8-K filing, must disclose in its most recently filed report on Form N-SAR or N-CSR that it intends to disclose these events on its website and must specify its website address. This website disclosure would be required to be made available on the company website for at least twelve months after the company initially posts the disclosure and must be retained by the company for at least six years.

The investment company would be required to file a copy of its code of ethics and amendments to that code as an exhibit to its report on Form N-SAR or N-CSR.

The Proposal will be open for public comment for 30 days after publication in the Federal Register. In response to public comment, the SEC will consider changes to the Proposal prior to adoption.

Anticipated Timeframe for Adoption

The SEC is requesting comments on the Proposal by no later than November 29, 2002. The Act mandates that the final rules be adopted no later than January 26, 2003.


Footnotes:

1: The Proposal also goes beyond the provisions of Section 406 of the Act by requiring a company to include its chief executive officer within the coverage of its code of ethics and by requiring it to file the code of ethics as an exhibit to its annual report.

2: The SEC noted that although the company would retain discretion to determine the identity of the appropriate person or persons, such person should not be involved in the matter giving rise to the conflict of interest. Furthermore, the person identified in the code of ethics should have sufficient status within the company to engender respect for the code of ethics and the authority to adequately deal with the persons subject to the code of ethics regardless of their stature in the company.

3: The concerns regarding the identification of appropriate persons for the reporting of potential conflicts of interest discussed above would similarly apply to the reporting of violations of the code of ethics.

4: The SRO Proposals, unlike the Proposal, require listed companies to adopt a code of conduct.

5: The NYSE proposal would require that the code be posted on the company's website.

6: Any waiver of the code of conduct for directors and executive officers must be approved by the listed company's board of directors or a committee thereof.

7: The Proposal suggests that a foreign private issuer that chooses to disclose changes to, or grants of waivers from, its code of ethics will be subject to the same notice and disclosure requirements in its most recently filed annual report on Form 20-F or 40-F. However, the SEC indicated in the Proposal that they will encourage foreign private issuers to make these disclosures promptly on Form 6-K or on their company website.

8: In order for the disclosure to apply to the investment company's principal underwriter, the principal underwriter must be: an affiliated person of the investment company or the investment company's investment adviser; or an officer, director, or general partner of the principal underwriter serves as an officer, director, or general partner of the investment company or its investment adviser.

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