A code of ethics for a firm sets the standard for basic principles of integrity, trust, and honesty. It gives the staff behavioral standards and addresses conflicts of interest. Ethical breaches can lead to big problems for firms, resulting in sanctions, fines, management turnover, and unwanted negative publicity. Having an ethical code can be a mitigating factor with regulators if a breach occurs.
When analyzing ethics codes, these are items to be considered:
- Make sure the board of directors receives relevant corporate information in a timely manner.
- Ethics codes should be in compliance with the corporate governance laws of the location country and with the governance requirements set forth by the local stock exchange. Firms should disclose whether they adhered to their own ethical code, including any reasons for failure.
- The ethical code should prohibit advantages to the firm's insiders that are not offered to shareowners.
- A person should be designated to be responsible for corporate governance.
- If selected management personnel receive waivers from the ethics code, reasons should be given.
- If any provisions of the ethics code were waived recently, the firm should explain why.
- The firm's ethics code should be audited and improved periodically.
In evaluating management, investors should:
- Verify that the firm has committed to an ethical framework and adopted a code of ethics.
- See if the firm permits board members or management to use firm assets for personal reasons.
- Analyze executive compensation to assess whether it is commensurate with responsibilities and performance.
- Look into the size, purpose, means of financing, and duration of any share-repurchase programs.
Beside the management, we have to be aware of the Audit committee, the Nominations committee and other Board committee. We need also to be aware of the remuneration and compensation package to analyze if they are tied with their responsibilities and performance.
The Audit committee ensures that the financial information provided to shareholders is complete, accurate, reliable, relevant, and timely. Investors must determine whether:
- Proper accounting and auditing procedures have been followed.
- The external auditor is free from management influence.
- Any conflicts between the external auditor and the firm are resolved in a manner that favors the shareholder.
- Independent auditors have authority over the audit of all the company's affiliates and divisions.
- All board members serving on the audit committee are independent.
- Committee members are financial experts.
- The shareholders vote on the approval of the board's selection of the external auditor.
- The audit committee has authority to approve or reject any proposed non-audit engagements with the external audit firm.
- The firm has provisions and procedures that specify to whom the internal auditor reports. Internal auditors must have no restrictions on their contact with the audit committee.
- There have been any discussions between the audit committee and the external auditor resulting in a change in financial reports due to questionable interpretation of accounting rules, fraud, etc.
- The audit committee controls the audit budget.
Investors should be sure a committee of independent board members sets executive compensation, commensurate with responsibilities and performance. The committee can further these goals by making sure all committee member s are independent, and by linking compensation to long-term firm performance and profitability.
Investors, when analyzing this committee, should determine whether:
- Executive compensation is appropriate.
- The firm has provided loans or the u se of company property to board members.
- Committee members attend regularly.
- Policies and procedures for this committee are in place.
- The firm has provided details to shareholders regarding compensation in public documents.
- Terms and conditions of options granted are reasonable.
- Any obligations regarding share-based compensation are met through issuance of new shares.
- The firm and the board are required to receive shareholder approval for any share-based remuneration plans, since these plans can create potential dilution issues.
- Senior executives from other firms have cross-directorship links with the firm or committee members. Watch for situations where individuals may benefit directly from reciprocal decisions on board compensation.
The nominations committee handles recruiting of new (independent) board members. It is responsible for:
- Recruiting qualified board members.
- Regularly reviewing performance, independence, skills, and experience of existing board members.
- Creating nomination procedures and policies.
- Preparing an executive management succession plan.
Candidates proposed by this committee will affect whether or not the board works for the benefit of shareholders. Performance assessment of board members should be fair and appropriate. Investors should review company reports over several years to see if this committee has properly recruited board members who have fairly protected shareholder interests. Investors should also review:
- Criteria for selecting new board members.
- Composition, background, and expertise of present board members. How do proposed new members complement the existing board?
- The process for finding new members (i.e., input from outside the firm versus management suggestions).
- Attendance records.
- Succession plans for executive management (if such plans exist).
- The committee's report, including any actions, decisions, and discussion.
Additional or other board committees can provide more insight into goals and strategies of the firm. These committees are more likely to fall outside typical corporate governance codes, so they are more likely to be comprised of members of executive management. Be wary of this-independence is once again critical to maintain shareowners' best interests.
I'll continue on my next post regarding the companies' policies with regard to voting rules. Cheers.