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notizie di POLITElA, XXIV, 89, 2008. ISSN 1128-2401 pp. 179-189

Reinventing the Corporate Ethics Officer:

A Strategy for Superior Governance

and Integrity W. MICHAEL HOFFMAN* AND MARK ROWE**

179

The past five or six years have brought unprecedented numbers of senior corporate executives into the limelight for the wrong reasons. Their names, once celebrated for pushing the envelope of conventional business practice, are now condemned for the same reason. While the news media have tended to focus on personalities, such as Skilling, Lay, Fastow, Kozlowski, Ebbers, Black and Tanzi - because executives in handcuffs make great pictures - it is clear that the circumstances and causes of the corporate scandals we were much more complicated than the rise and fall of clever but dishonest individuals whose fraudulent schemes caught up with them and their organizations.

In this paper we will share our view that the corporate scandals we have witnessed are more than failures of management; they are failures of governance for which boards of directors must also take responsibility. Secondly, the argument will be made that many corporate efforts to manage ethics within organizations are not working as well as they might because they are not sufficiently integrated with

* Founding Executive Director, Center for Business Ethics (CBE) and Rieken Professor of Business and Professional Ethics, Bentley College, Waltham, Massachusetts, USA. ** Director, Compliance and Ethics Advisory Services, SAl Global (Compliance Division, Americas) and CBE Research Fellow.

This paper has been adapted from the authors' articles, "The Ethics Officer as Agent of the Board: Leveraging Ethical Governance Capability in the Post-Enron Corporation," Business and Society Review, 112,4 (December, 2007), and "The Ethics Officer and the Board: Partners for Effective Ethical Governance," Ethikos, 21, 2 (September/October, 2007).

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1 )(0 Reinventing the Corporate Ethics OtTicer

corporate governance efforts. Th irdly, we will offer a proposal b y which fundamental improvements might be made in the approach to ethics and governance.

Ineffective Governance: An Overlooked Corporate Malaise

Without in any way minimizing or excusing the conduct of senior executives in cases like Enron, WorldCom and Parmalat, we believe there is another factor that has aided and abetted their misconduct: the failure of boards of directors, as the ultimate guardians of corporate integrity and fiduciary responsibility, to exercise effective ethical oversight of corporate management and show leadership in the development of a culture of integrity.

Even though the vast majority of directors undoubtedly carry out their respons ib ilities with diligence and fortitude, unfortunately some boards have defaulted to passivity, acquiescence and even indifference. Worse still, in some cases, there was knowledge and collusion of the b oard in the misdeeds of management. Investigators and commentators have pointed to boards rife with conflicts of interest and lulled by complacency, directors who were inadequately qualified, prepared or equipped for the rigors of their role, and boards that simply did not exert the requi site authority.

In the United States, several congressional and judicial inquiries into corporate scandals have concluded that inadequate board oversight of senior management has b een a s i gnifi cant or even dominant cause of corporate misdeeds. Two examples that com e to mind are the Report of the U.S. Senate ' s Permanent Subcommittee on In vestigations of the Commi ttee of Governmental Affai rs -actually entitled "The Role of the Board of Directors in Enron's Collapse" 1 - and the report of the court-appointed monitor, Richard Breeden , into what happened at WorldCom2. The bottom line is that Enron , WorldCom and the other major corporate scandals, which have rocked the world's capital markets and destroyed ordinary people's livelihoods, were as much failures of corporate governance a anything else.

On the other side of the world, a Royal Commission inquiry into Australia's l arg est ever corporate collapse, HIH I nsurance , which imploded in 2001 with losses of over $5 billion , found the board of directors to have been seriously deficient in its oversight of senior management3. One of the Commission's findings is so relevant to the points we will be making that we quote from its report:

During the inq uiry there arOf;e many instances that caused [the Commission 1 great

concern about the information flow to the board. There were occasions when there were

material omissions from information given to the board, to the point where the information

provided was misleading. Directors can do little if they arc misled. Bul the question that

arises is whether appropriate checks and balances were ill plaee to minimise both the risk

that happening ane it ; effect if it did ocelli',

.lust as the HIB board was dominated by the company's chairman and CEO.,

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W. Michael Hoffman and Mark Rowe 181

Ray Williams, the board of Parrnalat in Italy was under the thumb of Calisto Tanzi, founder, chairman and CEO, whose family controlled 51 percent of the company's shares. Admittedly, Parmalat's ownership structure made the board's job very challenging, but the extent to which Tanzi and his group of insiders were able to act at will was staggering. They had the freedom to effectively invent assets to offset as much as $16.2 billion in liabilities, and falsify accounts over a IS-year

n period, eventually forcing the $9.2 billion company into bankruptcy in 2003. It e

Development of Ethics and Compliance Programs

For a number of years, corporations - large American ones especially - have been making efforts to promote ethical and legally compliant business practices in more systematic ways than was previously the case. In fact, this effort has been ongoing in many large U.S. corporations for over 20 years, with formal ethics and compliance programs now commonplace. Originally, companies were motivated by the defense industry scandals of the 1980s (and the resulting initiative towards self-regulation), as well as the mandate for legal compliance and the prevention of criminal conduct contained in the Federal Sentencing Guidelines for Organizations (FSGO) of 19914. Companies wanted to avoid the potential for fines i the tens or even hundreds of millions of dollars, which could be imposed by fed tal judges if they found that criminal misconduct had occurred because of inadequate attention to the FSGO.

Even before Enron and the other scandals occurred, virtually all of the Fortune \.

1000 companies had adopted a code of ethics and established an ethics or compliance office to manage and oversee the company's integrity efforts. Almost all had a helpline to enable employees to report ethical concerns or seek advice and delivered training and communications related to ethics and compliance. These

fefforts were being managed in most large corporations by an ethics or compliance I

officer and overseen by a chief ethics officer. Some companies had even established a committee of the board of directors to consider ethics and compliance issues.

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If all these efforts were being made, it is reasonable to ask how and why did things go so badly wrong with the ethical governance of many prominent, well-respected and apparently healthy companies?

A preoccupation with rules, as opposed to values, and a failure to appreciate the importance of corporate culture on individual conduct are problems that have been

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182 Reinventing the Corporate Ethics Officer

appreciated to a greater extent in the wake of some spectacular corporate scandals. Post-Enron, an excessive focus on rules and box-checking, while neglecting the

spirit and values underlying the rules, are dangers that are widely appreciated. Similarly, it is increasingly well known that organizational culture can have a critical influence on individual conduct. c

We have mentioned the malevolent intent of certain corporate executives and the inadequacies of boards whose job it was to oversee them. But in the case of g governance failures, there is an additional factor that has so far received almost no c, attention: the ethics and compliance function in corporations has not been working b

in the way it should, especially in its relationship with the governance function. b

Ethics officers have not engaged boards of directors in sufficiently meaningful t1

Ifand collaborative ways to ensure the degree of ethical oversight necessary for truly effective corporate governance. There are at least three reasons for this. First, ethics officers are typically answerable primarily to senior management, and only incidentally to the board of directors; this creates an inherent conflict of interest in respect of .the ethics officer's ethical oversight role, since he or she may need to call to acc!ount the very people who can make or break his or her career. Secondly, 1.

in many - if not most - cases, ethics officers do not have the power, status and T:

p(authority in their corporations that they need to do their job effectively. Thirdly, the enature of the relationship, as presently structured, between ethics officers and their

boards does not provide the degree of mutual support or the leverage necessary for th

ethics and compliance programs, and the governance process as a whole, to reach or their full potential. it

The huge efforts made to bolster the corporate governance regime in the United at

States, following the corporate scandals, have been widely documented. The se

Sarbanes-Oxley Act of 2002 (SOX), the associated Securities and Exchange re

Commission (SEC) rule-making and the revised U.S. stock exchange listing to 101requirements have all enlarged the roles and responsibilities of boards of directors, suespecially their audit committees. However, we do not believe that any of these

reforms has addressed the above three issues underlying the failure of ethics and ob

compliance programs to operate with full force and effect. no po di1

Reinventing the Ethics Officer: A Proposal for Stronger Governance an of InCWe believe there is an opportunity to take an important step forward. We can not

only improve the standing and effectiveness of corporate ethics and compliance the M(programs but also fundamentally affect the ethical oversight capacity of boards of

directors. We are proposing that the ethics officer become an agent of the board of directors. We use the term "ethics officer" (EO) to refer to the person with day-to­ COl

day responsibility for managing a corporation's compliance and ethics program. But rna

our observations and proposal are applicable also to the senior executive to whom aff,

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the reports. whether designated Chief Ethics Offlc<:f or by some orher rltle.

Under the new model I,V, :.Ire proposing, the EO would be appointed hy the board, would report directly and be accountable to the board, and would have his or her compensation e( by the board. Furthermore, only the board would be capable of firing the EO. When we speak of reporting directlv to the hoard, we

mean a relationship of full This is a relationshi p that tar e:zceecls the giving of periodi c reports to the board about what is go ing on in the ethics and compliance program. The FSGO now recommends at least one such appearance before the board annually5 This may give the ethics officer limited "access" to the board but that is very different from a direct reporting relationship. Bear in mind that having access to the board does not necessarily enhance an ethics officer's independence from company management.

Now we will explore in more .detail the three reasons identified for what might be called "ethical governance dysfunction" in corporations.

i. An inherent of1nterest in Current EO Reporting Structures

The EO is the person with primary responsibility for ensuring a company ' s ethical performance; and the success of that mission depends on creating a universal expectation that no one in the company, no matter how senior, is above the law or

the requirement to behave ethically. Given the huge influence of senior management on a company's business performance and upon the corporate ethical culture - and, it has to be said, the historical culpability of senior executives in corporate fraud and abuses - one of the EO's most important responsibilities is to monitor and critique senior management's decision-making and conduct. However, when the company's reporting structure dictates that the EO is appointed by, reports to and is accountable to management- the situation in almost all companies -- this creates a conflict of interest and, inevitably, the possibility that the EO will be influenced, consciously or

subconsciously, by the self-preservation instinct. When that happens, the EO's objectivity and independence cannot fail to be compromised.

Clearly this conflict of interest can have far-reaching consequences, interfering not only with the EO's judgment and effectiveness in management oversight but potentially creating a company-wide perception th at management is treated differently from more junior employees. Besides the internal credibility of its ethics and compliance program, a company must also be acutely sensitive to the perception

of regulators, prosecutors and sentencing judges, especially given that the EO's independence and objectivity are relevant in assessing program effectiveness within the terms of both the FSGO and the Department of Justice's so-called "McNulty Memo," which provides guidelines for criminal prosecutions of corporations6.

By fundamentally altering the nature of the EO's relationship with the board, this conflict of interest is removed. In this way. the EO can operate independently of management with the direct authority of the board and all the protection that this affords.

184 Reinventing the Corporate Ethics

2. Ethics Officers Do Not Have Sufficient Power, Status and Authority

While there is no doubt, at least in the United States, that an ethics officer profession has become well established over the last decade?, we believe there is a worrying recent trend towards declining EO importance in the corporate hierarchy. This view is shared by other commentators, including Richard Bednar, Coordinator of the Defense Industry Initiative on Business Ethics and Conduct (DII). Bednar has noted a number of symptoms which mark this trend, which include: the EO not being regularly invited to the CEO's meetings with direct reports; the EO being asked to take on assignments unrelated to his/her core mission; senior management calls the general counsel instead of talking to the E08.

The proposal that the EO be an agent of the board has the important virtue of elevating the EO in the corporate hierarchy. It would also give the EO the very real authority that comes with any board appointment, and would signal to management and all employees, more than any board resolution, that the ethics and compliance program was endorsed and supported by the highest authority in the corporation.

3. Boards Need to Enhance Their Ethical Oversight Capabilities

It is not enough for directors to be diligent and vigilant; they need to assure themselves access, on demand, to high quality information about management proposals and activities, and about the company's operations in general. Ideally, the board will acquire such information in the ordinary course of an open and collaborative relationship with senior management. However, we have seen from recent history that boards cannot depend on management disclosure and must take a proactive approach to information gathering and processing.

By changing the nature of the EO's relationship with the board of directors, not only will the EO become more effective but also he or she can significantly assist the board in performing its ethical oversight responsibilities. This assistance might take the following forms: - Advising the board on acquiring, analyzing and acting upon information that is

pertinent to the board's ethical oversight responsibilities; - Assuring the board of a higher quality of information than it might otherwise

receIve;

Engaging the board in a more comprehensive process of continuous education to fully satisfy FSGO requirements;

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Guiding the board on suitable opportunitie for demonstrating ethical leadership and positively influencing the corporate culture in the manner contemplated by the FSGO.

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Developments Supporting an EO - Board of Directors Reporting Relationship

The FSGO requires that "individual(s) with operational responsibility [for the ethics and compliance program] shall report periodically to high-level personnel and, as appropriate, to the governing authority, or an appropriate subgroup of the governing authority, on the effectiveness of the ... program"9. We suspect that the reporting by EOs to the board, as it is presently being handled, is not appropriate -nor indeed will it be appropriate until there is a direct reporting relationship of the kind we are proposing.

A non-binding footnote to the SEC final rule applying to Section 406 of SOX provides that the "appropriate person" to whom violations of the code of ethics should be reported (almost certainly the EO) "should have sufficient status within the company to engender respect for the code and the authority to adequately deal with the persons subject to the code regardless of their stature in the company" I 0.

An analogy might be drawn from Section 301(2) of SOX, which requires the board of directors of a public company (through its audit committee) to be directly responsible for the appointment, compensation and oversight of the external auditors. We are effectively proposing that the board of directors be directly responsible for the appointment, compensation and oversight of the EO on the basis that independence and an absence of conflicts of interest are just as essential to the successful performance of the ethics and compliance function as to the external audit function.

Perhaps even more directly applicable is the analogy of compliance officers in the mutual fund industry. The SEC's Rule 38a-l requires each mutual fund to appoint a chief compliance officer (CCO) who must report directly to the fund's board of directors. The rule contains several provisions expressly designed to promote the independence of the CCO from the management of the fund. For example, only the fund board can hire or fire the ceo; and the fund board (including a majority of independent directors) must approve the designation of the eeo and must approve his/her compensation (or any changes in his/her compensation) .

Anticipated Objections and Rebuttals

From interviews and conversations with current and retired EOs, we are aware that our proposal does not enjoy universal support, though we would respectfully suggest that popularity is not always the best predictor of merit.

Some critics have said our proposal would have no value at their organizations because their senior management is highly ethical. This position is at best optimistic, perhaps naIve, and possibly even complacent; it takes no account of the

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186 Reinventing the Corporate Ethics Officer

fact that even managers with a longstanding reputation for integrity can, and sometimes do, buckle under extraordinary pressure, allowing th eir ethical jud gment to be compromised by what they see as overr iding business

directors (as opposed to management) because the board comprises outsiders who meet infrequently, and who, therefore, are out of touch with the company's operations. This argument reflects a limited view of how a board ought to work -

relationships with individual directors. Some people to whom we have spoken believe that if the EO were an agent of

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considerations. And, of course, management teams come and go.

Others contend it is impractical for the EO to report directly to the board of

and ignores what is happening with a lot of boards. Throughout the year, directors are frequently engaged in company business outside of full board meetings, both as individuals and in board committees. In any event, the EO's access to the board should not be limited to formal meetings - many EOs currently develop

the board, management would be less inclined to share information. This position assumes that under the current reporting model, management always shares information with the EO; that is certainly not always the case, as we know from anecdotal evidence, media reports and deposition evidence in legal cases. As agent of the board, we contend that such information sharing with the EO would increase.

Some fear that our proposal would preclude a collaborative relationship between the EO and man agement. On the contrary, when implemented enhancing open appropriately we feel it would enable the EO to serve as an important conduit Connecting the between management and the board; and if management is operating in the right of directors in tl way for the right reasons there is nothing to hide from the board. The questio

Others say the inherent conflict of interest point applies not only to EOs but directors and st" also to internal auditors, lawyers and accountants. To be sure, people in these capabilities, bUl functional areas can have self-interested reasons to manipulate the truth and not almost certainly report wrongdoing. However, the functional responsibilities of professionals in the proposal is u

many EOs.such areas may include, but are not primarily dedicated to, the assurance of the Whi ethical health and integrity of the organization. For the EO, however, this is steps we are pro precisely the primary mission, which makes it especially important that ethical governar management not apply undue pressure. necessary to inst,

Finally, it has been said that boards have been culpable themselves, and that having the EO report directly to the board will not necessarily change that. This is true if the board is ethically indifferent or worse; but if the EO is reporting directly Conclusion to the board, there is every prospect of raising the board's level of ethical awareness and preparedness to perform its oversight duties properlyll. This is at Unfortunately, COlthe heart of our proposal: having the EO report directly energizes the board's apparently increacommitment to ethics and compliance, and sound governance in general.

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W. Michael Hoffman and Mark Rowe 187

Ethical Governance in a Globalized Business Environment

Although our observations are drawn from the U.S. experience, the need to ensure ethical business practices is a universal concern. In an increasingly interconnected and transparent global business environment, corporations need to be responsive to stakeholder concerns about trust, integrity and sound governance. This should be true whether the applicable corporate governance sy stem is the shareholder­focused Anglo-Saxon liberal model used in the United States, the United Kingdom, Australia, Canada, New Zealand and many other countries, the version of the stakeholder model adopted in Scandinavia, Japan, Germany and much of Continental Europe, or the Latin version that works with the preponderance of family-owned companies in Mexico, Italy, Spain, France (to a certain extent), Brazil, Argentina, and other countries in South America.

In different countries around the world, shareholders and stakeholders, including investors, regulators, judicial agencies, the public and (where there is a free press) the media, have different priorities and different conceptions of ethical best practices in business. But in all of these environments we would contend that monitoring and oversight of top management by the board of directors is the most critical aspect of the governance system in preventing undesirable conflicts of interest, management misconduct and other abuses. We would respectfully suggest that anything which can leverage the board's ethical oversight capacity, while also enhancing operational efforts to promote an integrity culture, should be welcomed. Connecting the corporate ethics and compliance function more closely to the board of directors in the way we propose is an effective way to accomplish this.

The question arises as to how our proposal might take effect. Boards of directors and stakeholders might appreciate its potential for enhancing governance capabilities, but board resolutions to change the EO reporting structure would almost certainly face obstructions in implementation. We have acknowledged that the proposal is unlikely to be popular with companies' senior management or even many EOs. While it would be preferable for companies to voluntarily take the steps we are proposing, thereby signaling a strong commitment to truly effective ethical governance, we suspect a legislative or regulatory intervention will be necessary to install EOs as agents of the board.

Conclusion

Unfortunately, corporate scandals involving ethical misconduct have occurred with apparently increasing frequency in all of the world's financial markets. The causes nd consequences are highly complex and varied but it has been possible to

···.;- some common themes. One of the most significant, in our view, has been the failure of corporate governance sy stems - and specifically the board of

188 Reinventing the Corporate Ethics Officer

directors in many cases - to oversee and, if necessary, resist senior management's conduct and decision-making in a proactive and robust manner. As companies think more strategically and systematically about institutionalizing ethics and legal compliance into their cultures, boards of directors must be involved to the extent necessary to make ethics and compliance an effective component of the governance process. Furthermore, ethics officers (or whoever in the company manages and oversees integrity initiatives) should not be a part of senior management but should be appointed by and operate as agents of the board of directors. This will address some systemic problems we have identified. It will also provide additional leverage for corporate governance reform and will further our pursuit of corporate accountability and trust, which are essential for innovation, investment and the generation of sustainable economic and social value.

Notes

I "The Role of the Board of Directors in Enron' s Collapse," Report of the Permanent Subcommittee on Investigations of the Committee of Governmental Affairs, United States Senate , dated July S, 2002. Available online at:

http://jlJfindlaw.com/newsfindlaw. comlcnn/ docs/enron/senpsi 7080 2rpt.pdj

2 Richard C. Breeden, "Restoring Trust: Report to The Hon. Jed S. Rakoff, The United States District Court for the Southern District of New York, on Corporate Governance For The FutUre of MCI, Inc.," dated August 2003. Available online at: http://jlJfindlaw.com/newsfindlaw. com/hdocs/docs/worldcomlcorpgov82 603 rpt.pdj

3 For a discussion of the governance failures at HIH Insurance in Australia and at Parmalat in Italy, see: Antoinette Richardson, "Corporate Governance Models: the HIH Insurance and Parrnalat Experience." Available online at: http://www.griffith.edu.au/school/gbs/afe/ ymposium/2006/proceedings/Richardson.pdj

4 For background and detailed information on the Federal Sentencing Guidelines for Organizations, visit the website of the United States Sentencing Commission at http://www.ussc.gov/orgguide.htm.

5 The Application Notes for §SB2.! (b )(2) of the Federal Sentencing Guidelines for Organizations

state: "If the specific individual(s) assigned overall responsibility for the compliance and ethics program doeS not have day-to-day operational responsibility for the program, then the individual(s) with day-to-day operational responsibility typically should, no less than annually, give the governing authority or an appropriate subgroup thereof information on the implementation and effectiveness of the compliance and ethics program."

6 This memorandum, dated December 12, 2006, from Deputy Attorney General of the United States, Paul McNulty, to United States Attorneys, gives updated guidelines for prosecuting

corporations. It includes nine factors to consider when weighing whether to charge or negotiate a plea in corporate criminal cases: (1) Nature and seriousness of the offense; (2) Pervasiveness of wrongdoing in the corporation, including management complicity; (3) History of prior conduct; (4)

Corporation's timely and voluntary disclosure of wrongdoing, and willingness to cooperate; (5), ;

Existence and adequacy of pre-existing compliance program; (6) Corporation's remedial actions; (7)

Collateral consequences; (S) Adequacy of prosecution of individuals responsible for corporation's

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7 This is evidenced by the growth in memhersh.ip of the two leading profes;;ional associations forr tlllCS and compliance practitioners, the Ethics & Compliance Ofticer Association (which has 1,150individual and 650 organizational members) and the Society of Corporate Compliance and Ethics(with over 800 individual members and more than 30 corporate members).x For a fuller consideratIOn of Bednar's ideas , see: E.L.Sherwood, "The Evolvll\g Position of theEthics Officer, " Elhikos and Corporate Conduct Quarterlv, Vol. 20, No. I 120(6): i 0-19.9 Federal Sentencing Guidel ines for Organizations, §8B2. j (b)(2)(C) .!O Federal Register, Volume 68, No. 21, (January 31,20(3), page 5118, footnote 45.II The board of directors is the last resort, internal ly at least, for ensuring a company ' s ethicalstandards arc upheld . Although hopefu lly a rare occurrence, we recognize the fact that a board ofdirectors could act in eth ical ly wrongheaded ways, even to the extent of colluding with managementin the pursuit of questionable aims. [n those circumstances, we acknowledge that even an EO who isap pointed by, reports d irect ly to, and is answerable to the board, may not be able to keep thecompany on an ethical course. This is clearly a somewhat extreme situation and is likely to requirethe i n tervent i on of some external agent; perhaps outside regulatory authorities alerted by awhistleblower, or a sharehol der suit against management and the board.