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On Nov. 1, a delayed consequence of the Sarbanes-Oxley Act took effect � the U.S. Sentencing Commission’s Sentencing Guidelines revising the elements of and heightening the need for corporations to implement compliance and ethics programs. Yes, you read correctly � ethics. This action, while not widely noticed, may offer more potential for reform than past regulatory efforts. As history shows, laws alone are not enough. Companies need to practice genuine ethics as well. Ironically, these Nov. 1 changes take effect as reports surface about something that would have been unthinkable just two years ago � challenges by business to the rule making of and intensified scrutiny by the Securities and Exchange Commission. This push-back is taking place as the number of high-profile corporate scandals begins to diminish and as memories of prior scandals begin to fade. Some suggest that Sarbanes-Oxley and the plethora of resulting regulations are putting an unreasonable regulatory burden on American corporations. Indeed, Hank Greenberg, chief executive officer of AIG, was one of the more vocal critics of today’s increased regulatory scrutiny (until recently), referring to some of the new regulations as “foolishness.” (AIG now faces scrutiny by the SEC, the Justice Department, and the New York attorney general.) No one (perhaps not even Greenberg) would argue, however, that some exceedingly bad actors caused many of the spectacular corporate failures in recent years. REGULATORY D�J� VU Controversies over corporate ethics are nothing new, and neither are efforts to solve the problem through legislation. Consider the following findings of a Senate committee investigating a stock market crisis: •�”Self-dealing and outright fraud (not the least of which involved a gigantic, rapidly growing energy operation) have become associated with erosion of the stock market.” •�”Leading Wall Street investment banks are under fire for their lending and investing practices, including transactions designed to allow companies to misstate their financial results.” These findings are not from the 2002 investigations of Enron � they are from a 1932 Senate committee that investigated the causes of the 1929 stock market collapse. (The energy company then was run by Samuel Insull.) This 1932 investigation resulted in passage of various laws that 70 years later form the backbone of the federal securities law scheme. Or consider another quote about the anxieties of corporate officers and directors over “the act”: •�”This consternation can be attributed, in significant part, to the spectre which some commentators have raised of exposure to enforcement action, and perhaps criminal liability, as a result of technical and insignificant errors in corporate records or weaknesses in corporate internal controls.” This statement is not referring to Sarbanes-Oxley. It is from the 1979 SEC policy statement on the Foreign Corrupt Practices Act, a major piece of post-Watergate legislation. The act resulted from the “most devastating disclosure” � “the fact that, and the extent to which corporations falsified entries in their own books and records.” That falsification resulted in the accounting provisions of the Foreign Corrupt Practices Act, which require that all public corporations maintain a system of internal controls to ensure that transactions are recorded in accordance with management’s authorization and that the corporation’s assets are safeguarded. And what did the SEC indicate was the “most effective antidote” to these problems? An “increase in the numbers and responsibility of independent directors” and “effective audit committees composed of independent directors.” So 25 years after passage of the Foreign Corrupt Practices Act, what happened? Alan Greenspan, chairman of the Federal Reserve, offered his opinion: “The historical guardians of financial information were overwhelmed.” One of these groups of guardians was the supposedly independent directors whose job it was to police management. They didn’t, and management, left unsupervised, succumbed to human nature. Greed and self-interest overcame ethics and judgment, resulting in several top corporations � Enron, WorldCom, Healthsouth, Tyco, and ImClone � becoming bywords for business corruption. Sarbanes-Oxley addressed many of the perceived failings of directors. In areas in which directors failed to perform critical tasks or exhibited an inability to appropriately exercise discretion, Congress did the jobs for them (CEO/CFO certifications of financial statements) or removed their discretion (prohibition on personal loans to directors and officers). Perhaps the most mentioned and criticized section of Sarbanes-Oxley, however, is Section 404, with its requirement that auditors attest to companies’ internal controls. Significantly, Sarbanes-Oxley did not mandate a single additional internal control. It simply required an audit of the controls that had been mandated by the Foreign Corrupt Practices Act some 25 years earlier. So why is there director anxiety about Sarbanes-Oxley? Although these fears exist, some say convincingly that neither the act nor any resulting regulations has increased directors’ liabilities. This view has been stated publicly by high-level SEC officials and been reaffirmed by Norman Veasey, a recently retired justice of the Delaware Supreme Court. Yet the directors know from history that businessmen stumble, scandal occurs, and prosecutors come calling. REQUIRING CORPORATE ETHICS Congress knows this too. And that’s why the regulations written to implement one little-noticed section of Sarbanes-Oxley offer something new not only to cause concern in the boardroom but to further empower directors in their oversight role. Section 805 mandated a review of the Sentencing Guidelines to ensure that “the guidelines that apply to organizations . . . are sufficient to deter and punish organizational criminal conduct.” Revisions to the organizational guidelines took effect on Nov. 1. Although the Supreme Court is now reviewing the constitutionality of the Sentencing Guidelines, the congressional concern about corporate compliance and ethics is likely to persist through any revisions. The amendments now focus on the establishment of “effective compliance and ethics” programs. Compliance alone now is not enough � companies must consider an additional factor � ethics � in the establishment of such programs. Furthermore, as indicated in �8B2.1 of the Sentencing Guidelines, a precondition to an effective compliance and ethics program is promotion of “an organizational culture that encourages ethical conduct and a commitment to compliance with the law.” Of great importance to boards is the guidelines’ requirement that a compliance and ethics program be overseen and implemented by a company’s “governing authority” (i.e., its board of directors). The board is required to be knowledgeable about the content and operation of the compliance and ethics program. It must exercise reasonable oversight regarding the implementation and effectiveness of the program. Additionally, the board must appoint “high level personnel” (policy-making individuals) to oversee compliance. It must use reasonable efforts not to include within the “substantial authority” group (those having substantial discretionary authority) individuals who are known (or should be known) to have engaged in illegal activities or other conduct inconsistent with an effective compliance and ethics program. Other elements of an effective plan include periodic communication about standards and “effective training programs” for all employees (including the board of directors). The organization must take reasonable steps to ensure compliance, including monitoring and auditing to detect criminal conduct. It must periodically evaluate the effectiveness of the ethics program, and it must publicize a system whereby employees may report potential criminal conduct without fear of retaliation. Finally, any program needs to be consistently enforced and promoted through “appropriate incentives” to comply with the program and “appropriate disciplinary measures” for noncompliance or for failing to take reasonable steps to prevent or detect criminal conduct. These new guidelines address the root cause of many of the corporate failures of recent years � ethical laxity among corporate executives. They are meant to address the real deficit that confronts corporate America � the trust deficit, the substantial loss of trust in corporations and their executives by the public and investors. Unfortunately, Kenneth Lay and Jeffrey Skilling may not be mere anomalies of the corporate world. They may be products of a poisoned corporate society over which corporate directors must now exercise more oversight. THE CORPORATE DNA Commentators, puzzled by Skilling’s actions at Enron, ask, “How could a Harvard MBA act so unethically?” But it’s not the MBA � it’s the DNA. This is what SEC Chairman William Donaldson addressed in early 2003 when he stated: “In my mind, the most important thing that a board of directors should do is determine the elements that must be embedded in the company’s moral DNA. . . . It should be the foundation on which the board builds a corporate culture based on a philosophy of high ethical standards and accountability. This culture should penetrate every level of the organization and influence all of the board’s decisions including the selection of a CEO and the senior management team who will ultimately ensure that the company’s operations reflect its philosophy.” The Securities Act of 1933 and the Securities Exchange Act of 1934 did not prevent fraud. Neither did the Foreign Corrupt Practices Act. Nor will the Sarbanes-Oxley Act of 2002 or the rules and regulations it mandated. At most, increased criminal penalties perhaps will cause executives to think twice before engaging in questionable activities. Ethics is a hard thing to monitor. When seemingly de minimis ethical and compliance violations are overlooked, the ethical alarm bells don’t sound. That is why adherence to the ethics and compliance requirements of the organizational guidelines will require more than a “check the box” approach. Enron, for example, had an “award winning” 60-page-plus code of ethics, key provisions of which were waived to allow Andrew Fastow’s off-the-books partnerships. Whenever the provisions of a code of ethics are set aside, management must stop and challenge the basis for such decisions. Corporate directors must now be sure to set the “tone at the top.” They must require that high ethical standards be a part of each company’s culture. Effective codes of ethics must be “living” documents rather than mere framed pieces of paper hanging on corporate walls. They must be encouraged and valued at the highest levels of management. They must be embodied in the decisions made every day by people throughout the corporation. Even de minimis ethical violations cannot be sanctioned. Had directors of some of the failed companies been more vigilant about this issue, would things have been different? Some prefer to think so. Gary M. Brown is a shareholder in the Nashville office of Baker, Donelson, Bearman, Caldwell & Berkowitz, where he chairs the business department. Former special counsel to the Senate Committee on Governmental Affairs in the investigation into the causes of the collapse of Enron, Brown counsels boards on regulatory compliance and corporate governance. Brown can be reached at [email protected].

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