February 9, 2022

Moralized Corporate Governance: How Codes of Ethics Are Changing

Codes of ethics are adapting to ESG issues:

The average length of ethics codes increased from 6,054 words in 2008 to 7,821 words in 2019, an average increase of 29 percent. Although a handful of firms defied the trend and shortened their codes, most increased by a relatively large amount. Terms such as social media, slavery, sustainability, footprint, and trafficking appeared not at all or only infrequently in 2008 but appeared with significantly higher frequencies in 2019.

Consistent with codes of ethics playing an important part in building and maintaining corporate culture, we document a positive linkage between Trust and Moral Behavior words (e.g., ethics, respect, and trust) and being selected as a most ethical firm by the Ethisphere Institute. We also find that changes in Inappropriate Behavior words are positively linked with changes in ESG ratings

That’s part of the conclusion from Notre Dame professors Tim Loughran, Bill McDonald and James Otteson in a recent study (and next time you review your code, it’s worth checking out their detailed appendices about word count, companies studied, and specific words related to Environmental, Social & Governance issues).

Companies have leeway in deciding whether their code of ethics should meet the bare minimums required by Item 406 and NYSE and Nasdaq listing standards. When Item 406 was adopted nearly 20 years ago, there were a lot of folks in the “bare minimum” camp. Now, this study suggests that companies are using the code of ethics to hold their employees & executives to a higher standard.

In this “Money Stuff” column, Matt Levine points out the reasons that companies might have for going above & beyond: using the code as a management tool to minimize legal & reputational risk, using the code as an advertising tool to shareholders & other stakeholders – especially with ESG getting so much attention. Companies should exercise some caution in adding commitments, though. Matt explains the risk:

[T]he biggest problem with a strict and specific code of ethics is that everything is securities fraud. If someone at your company does something bad and the stock goes down, your shareholders will sue, claiming in essence that you didn’t tell them that you were doing the bad thing. Technically, though, securities law does not require companies to disclose every bad thing; for the most part it penalizes active lies, not passive omissions. So the shareholders will not say “you didn’t tell us about the bad thing”; rather, they will say “you actively lied to us, saying or implying that you were not doing the bad thing.”

Codes of ethics are very helpful to the shareholder plaintiffs here, meaning that they are dangerous for the company, and the more strict and detailed they are the more dangerous they are. If your code of ethics says “executives are expected to act ethically where appropriate,” and your chief executive officer is revealed to be a sexual harasser and the stock drops, you can say “well that vague statement couldn’t possibly have induced anyone to buy our stock” and maybe win the shareholder lawsuit. If your code of ethics says “we have zero tolerance for sexual harassment of any kind and we hold everyone accountable immediately,” then it will be easier for shareholders to argue that they were deceived.

Those takeaways come in big part from this 2020 Davis Polk memo and a $240 million securities class action settlement against Signet Jewelers. Not only could these shortfalls eventually be used in litigation, but you might find yourself in a disclosure and listing quandary early on, due to the requirements under Item 5.05 of Form 8-K and listing standards to promptly announce waivers from the code.

All that to say, it’s tempting to make sweeping ESG commitments – and shareholders, employees & communities are definitely pushing for them. But companies need to be able to back up those commitments, and it may fall to securities lawyers to ask the hard questions when the code gets reviewed.

Liz Dunshee