Are Codes of Conduct Toothless Tigers? A Call for Reform
POMERANTZ MONITOR | NOVEMBER DECEMBER 2020
In the wake of the Enron debacle, Congress compelled companies to adopt codes of conduct intended to reform corporate governance and thwart recurrence of frauds upon investors. While the Sarbanes-Oxley Act of 2002 focused solely on misconduct by CFOs, the SEC expanded the scope of mandated codes to include all senior executives. The NYSE in turn required codes to be enacted by all listed companies, and the Council of Institutional Investors recommended model codes for a wide range of conduct.
Yet, with too few exceptions, courts have tossed this corporate governance tool into the dustbin, barring investors from recovery for securities fraud upon revelation of executive misconduct in violation of codes despite significant stock price declines. Courts have characterized such codes as mere aspirations, unworthy of reliance - more “puffery” than substance.
Pomerantz urges that this be remedied. Institutional investors should lobby the SEC or Congress to compel senior executives to certify personal and corporate compliance with the codes, just as they are required regarding the accuracy of financial statements and internal controls. This will shortcut the issue of whether codes of conduct are “actionable” statements. In the meantime, courts should otherwise recognize such claims and shift the focus to whether the company acted with scienter in failing to timely disclose material violations.
Examination of court decisions regarding sexual misconduct provides context for this issue.
The Good, the Bad and the Ugly
Sexual misconduct in executive suites may have been de rigeur during the Mad Men era, but is no longer tolerated. More recently, heads have rolled, causing stock prices to plummet with significant investor losses. Perhaps the most notorious recent episode involved McDonald’s, whose CEO Steve Easterbrook was fired in 2019 after admitting to a “consensual relationship” with an employee. Easterbrook nonetheless parted with a $40 million golden parachute. However, after further investigation, McDonald’s discovered that Easterbrook had lied about additional sexual relationships with employees, one of whom received substantial option bonuses. The company is now suing him to “claw back” his severance.
It remains to be seen how the investor lawsuits based on revelations of such misconduct, which are clearly contrary to codes of conduct, will fare. The Second and Ninth Circuit Courts of Appeal have generally upheld dismissal of such cases. Most recently, the CEO of Liberty Tax, Inc. was ousted after abusing his position to “date female employees and franchisees,” taking them “on business trips, ha[ving] sex with them in his office during work hours, and provid[ing] their friends and relatives with positions at Liberty.” When this misconduct was exposed and the company’s stock price fell, shareholders sued, claiming they had been misled by statements regarding the previous work of a compliance task that focused on the company’s internal controls and purported “commitment to ethics,” which had nonetheless failed to disclose investigation of such misconduct, e.g.:
Our compliance task force was very successful in analyzing, reviewing and evaluating the work of our compliance department and taking appropriate action to ensure that the standards of the Liberty brand are upheld and that those who do not uphold Liberty standards are exited from the Liberty system.
In upholding dismissal of this action, the Court of Appeals held that such statements regarding ethical commitments were “inactionable puffery on which no reasonable investor would rely in making investment decisions.”
The Second Circuit’s mauling of code of conduct/ethical behavior-based claims echoes similar outcomes in the Ninth Circuit in Retail Wholesale & Dep’t Store Union Local 338 Ret. Fund v. Hewlett-Packard Co. That case arose out of HP CEO Mark Hurd’s dalliance with a public relations employee (a former “adult film” actress) using the firm’s expense account, which led to his ouster and HP’s stock price decline. In dismissing the claims that such misconduct contradicted HP’s Standards of Business Conduct’s (e.g. “we make ethical decisions”), the Court held that:
Defendants made no objectively verifiable statements during the Class Period. As one court has aptly written, a code of conduct is “inherently aspirational.” . . . Such a code expresses opinions as to what actions are preferable, as opposed to implying that all staff, directors, and officers always adhere to its aspirations.
On the other hand, while the Courts of Appeals have chilled securities fraud cases based on violations of codes of conduct, some district courts have been more receptive. By way of example, in In re Signet Jewelers Ltd. Sec. Litig., Chief Judge Colleen McMahon refused to dismiss claims arising from the company’s widespread pattern of sexual harassment of female employees, including comments on breast size, invitations to hot tubs, and “sexcapades,” revelations of which caused significant stock price declines. Such behavior belied the company’s code of conduct, which represented that it was “committed to a workplace that is free from sexual, racial, or other unlawful harassment”; that “[a]busive, harassing, or other offensive conduct is unacceptable, whether verbal, physical, or visual”; and that adherence to the code, including by senior executives, was of “vital importance.” In denying a motion to dismiss, Judge McMahon held:
While generalized, open-ended or aspirational statements do not give rise to securities fraud (as mere puffery), statements contained in a code of conduct are actionable where they are directly at odds with the conduct alleged in a complaint.
Soon thereafter, the defendants moved again to dismiss, citing the intervening decision by the Second Circuit in Singh v. Cigna Corp. In that case, investors claimed that Cigna’s subsidiary’s Medicare fraud belied the company’s code of conduct, which expressly affirmed the importance of “compliance and integrity, and the “responsibility to act with integrity in all we do, including any and all dealings with government officials.” The Court of Appeals held that such statements were a textbook example of “puffery.”
Following renewal of the motion to dismiss, Judge McMahon held that, given their “context,” Signet’s statements rendered them more reliance-worthy than Cigna’s:
Significantly, Cigna did not rule (as Defendants imply) that all statements in codes of conduct qualify as “puffery.” Rather, the Cigna court expressly stated that “‘context’ bears on materiality.
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Materiality depends upon a number of context- specific factors, including specificity, emphasis, and whether certain statements are designed to distinguish the company in some fashion that is meaningful to the investing public.
In so ruling, Judge McMahon borrowed a page from Judge Rakoff’s decision in In re Petrobras Sec. Litig. which grew out of widespread bribery at the Brazilian oil and gas company (a case in which Pomerantz, as lead counsel, achieved a $3 billion settlement for defrauded investors):
[W]hen (as here alleged) the statements were made repeatedly in an effort to reassure the investing public about the Company’s integrity, a reasonable investor could rely on them as reflective of the true state of affairs at the Company.
The question remains whether the reliance-worthiness of statements regarding ethics and integrity should depend on the precision of the statements. Clearly, sexual harassment and bribery are unethical, and investors should be entitled to presume that corporate executives are not engaging in such misconduct. As such, investors should also be able to bring lawsuits to recover stock price losses caused by disclosure thereof.
Pomerantz leads the securities class action against Wynn Resorts Ltd., its former CEO Steven Wynn, its former General Counsel, and other officers and directors. The case alleges that the defendants recklessly disregarded, or actively covered up, a years-long practice of sexual misconduct by its founder and CEO, Stephen Wynn. The suit was filed in the wake of an explosive Wall Street Journal article published in late January 2018 which detailed dozens of accounts by Wynn employees about this misconduct, which caused the company’s stock price to crash 10% that day, wiping out $2 billion in market capitalization. Although the company initially defended Steve Wynn, he was ultimately forced to resign in early February 2018. Extensive investigations ensued, by both the Nevada Gaming Control Board and Massachusetts Gaming Commission, which confirmed many of the Wall Street Journal article’s accounts and that “settlements” were paid to silence several accusers. Notably, Wynn was found to have paid $7.5 million to a former employee who claimed Wynn had forced her to have sex with him.
The complaint alleges that during the period of the alleged misconduct, the defendants falsely assured investors that the company had a rigorous code of conduct in place that required compliance with legal and ethical norms, and that the company had numerous policies and procedures to guard against sexual harassment and to investigate possible wrongdoing. In fact, the defendants failed to conduct investigations of the numerous complaints described above, in blatant violation of the code. Moreover, as we argued in our brief opposing defendants’ motion to dismiss, these misrepresentations were particularly material in the context of Wynn’s business – because the applicable gaming regulations require their operators to meet “suitability” requirements. If the company harbored “unsuitable” actors such as Steve Wynn, it would be at serious risk of losing its lucrative gaming license, the lifeblood of its business.
Unfortunately, on May 27, 2020, the court granted the defendants’ motion to dismiss, including the code of conduct allegations, finding that such “aspirational” statements were not actionable under the federal securities laws. Pomerantz filed a second amended complaint on July 3, 2020. The Firm is considering its options in the event the court dismisses the case a second time.
Policy and Other Factors Warrant Actionability of Code of Conduct Statements
There are also strong policy reasons why code of conducts should not be deemed mere window dressing by courts. Going as far back as the 1970s, Congress and commentators have recognized the important role that codes of conduct play in setting the tone for corporate culture and “tone at the top.”
Indeed, in the wake of Enron’s allowing its CFO Andrew Fastow to invest in off-balance sheet enterprises (contrary to the company’s stated policy against related party transactions), Congress compelled companies to adopt financial codes of conduct and to disclose when they were waived. In support of regulations implementing these requirements, and expanding them to all senior executives, the SEC stated:
Increase[d] transparency of certain aspects of a company’s corporate governance … should improve the ability of investors to make informed investment and voting decisions. Informed investor decisions generally promote market efficiency and capital formation.
(Emphasis added). As such, Congress and the SEC clearly presumed investors would rely upon such codes when making investment decisions.
Congress’ 1991 adoption of Federal Sentencing Guidelines further supports treating codes of conduct as substantive. Those guidelines provided that if a company is found criminally liable as a result of its employees’ unlawful actions, the company could reduce its penalty by showing that it had established an effective program to prevent and detect violations of law, including a code of conduct. The 2018 edition of the U.S. Sentencing Commission’s Guidelines Manual states that, in deciding whether to reduce corporate punishment, courts should evaluate whether the company has an “effective Compliance and Ethics Program” which entails “promot[ing] an organizational culture that encourages ethical conduct and a commitment to compliance with the law.” Further, the Manual states that an organization should take reasonable steps “to ensure that its compliance and ethics program is followed, including monitoring and auditing to detect criminal conduct” and should periodically evaluate the effectiveness of such program as well as provide incentives to “perform in accordance with the compliance and ethics program.”
Empirical studies evidence that investors attribute significant value to a corporation’s reputation for integrity. This is best demonstrated by the price reactions that occur when material violations of codes of conduct are revealed. A recent study by Shiu-Yik Au, Ming Dong, and Andréanne Tremblay, How Much Does Workplace Sexual Harassment Hurt Firm Value? concluded that firms with documented patterns of sexual harassment have experienced annual shareholder value loss of $0.9 to $2.2 billion. “High [sexual harassment] scores are also associated with sharp declines in operating profitability and increases in labor costs. These results indicate that sexual harassment has a highly detrimental effect on firm value.”
In sum, rather than disregarding codes of conduct, courts should recognize their reliance-worthiness. This does not mean that all violations will result in successful claims. Plaintiffs must still prove not only loss causation (i.e., that disclosure of the violations caused significant stock price declines), but also scienter (i.e., that defendants acted in reckless disregard of the code’s statements). Pomerantz also urges institutional investors to lobby corporations, Congress and the SEC to require senior executives to certify, to the best of their knowledge, compliance with such codes.