It is essential for companies to implement and maintain strong corporate governance practices, regardless of their size or industry. This is especially important for public companies or companies seeking to go public. Both the New York Stock Exchange (NYSE) and Nasdaq have rules that require companies to implement certain codes of conduct. In addition, laws such as the Sarbanes-Oxley Act of 2002 require companies to comply with certain corporate governance procedures.
Among corporate governance policies, a company’s code of conduct and ethics is one of the most important. Under Section 406 of the Sarbanes Oxley Act, companies must disclose that they have adopted a code of ethics. The SEC has titled this Item 406 of Regulation S-K.
The SEC’s Item 406
Item 406 of Regulation S-K requires companies to publicly file their code of ethics with the SEC. The company files the code as an exhibit to their Form 10-K annual report. The Form 10-K report provides a comprehensive overview of the company’s business and financial performance for the most recent fiscal year.
The code of ethics must aim to deter wrongdoing. It must also be designed to promote a set of corporate governance principles. According to item 406, this includes promoting:
(1) Honest and ethical conduct, including the ethical handling of actual or apparent conflicts of interest between personal and professional relationships;
(2) Full, fair, accurate, timely, and understandable disclosure in reports and documents that a registrant files with, or submits to, the Commission and in other public communications made by the registrant;
(3) Compliance with applicable governmental laws, rules and regulations;
(4) The prompt internal reporting of violations of the code to an appropriate person or persons identified in the code; and
(5) Accountability for adherence to the code.
There are several topics a company’s code of ethics is either required or recommended to cover. The Sarbanes Oxley corporate governance rules set out some of these topics. The stock exchange rules of NYSE and Nasdaq set them out as well.
Conflicts of Interest
Conflicts of interest are often not immediately recognizable. Therefore, it is important for the code of ethics to require prompt reporting of any potential conflicts involving an officer, director, or another employee. The code of ethics typically specifies that company personnel disclose these red flags the company’s general counsel. The policy usually specifies that concerns will remain confidential, and individuals will remain anonymous.
Related Party Transactions
The related party transactions section generally mandates that the company must review and approve transactions exceeding a specified dollar amount, often if the amount is over $120,000. Related parties include directors, director nominees, executive officers, beneficial owners of more than 5% of the company’s securities, and immediate family members.
Corporate Opportunities & Corporate Governance
The corporate opportunities doctrine relates to the duties of directors, officers, and controlling shareholders to advance the legitimate interests of the company. In other words, these individuals may not use corporate property or corporate information gained because of their position to advance their own personal interests.
A public company is required to make several filings with the SEC, both on a regular basis and in connection with specific transactions. This section of the code of ethics specifies guidelines that should be followed to ensure fair and accurate reporting of information to the SEC. It outlines the company’s internal controls and compliance procedures.
Insider Trading: An Important Part of Corporate Governance
Although a company often has a standalone Securities Trading Policy, the code of ethics will provide a general cautionary statement. The insider trading section makes it clear it is illegal to pass on insider information to another person who might trade securities based on that information. This insider information is referred to as material, non-public information (“MNPI”).
Corporate Governance Requires Fair Dealing
The fair dealing section requires directors, officers, and employees to deal fairly with competitors, customers, and suppliers. Unfair dealing practices, including concealment, abuse of privileged information, manipulation, and misrepresentation of material facts, are not tolerated.
Compliance with Laws, Rules and Regulations
To avoid law violations and reputational harm to the company, the code of ethics requires a company to abide by the laws of the cities, states, and countries in which it operates. This also extends to avoiding the appearance of impropriety.