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Ethical Corporate Governance

"The board's role in the oversight of a company's management of risk is a significant policy matter regarding the governance of the corporation," according to the SEC's Staff Legal Bulletin No. 14E (CF), dated October 27, 2009. One reason is that "ineffective oversight of the company's external financial reporting and internal control over financial reporting by the company's audit committee" is a material weakness according to the PCAOB's Auditing Standard No 5, paragraph 69. Ineffective oversight includes the failure to detect and disclose audit risks that include material illegal acts per Section 10A or material compliance violations that violate (1) the Code of Ethics,  (2) the corporate governance listing standards of the exchanges and (3) the safety and soundness regulations for federally insured firms and financial holding companies. These violations have a direct and material effect on the financial statements of federally insured institutions and financial holding companies per Sarbanes-Oxley 404 as multiple regulations require their remediation in early stages to restore compliance before the violations explode into systemic risk with firms in a troubled condition and poor management. These illegal acts are material misstatements that require remediation to prevent termination of federal deposit insurance, delisting of securities, fraudulent statements and qualified audit opinions. Ineffective oversight of compliance risk and audit risks is a material weakness that requires a qualified audit opinion. A qualified audit opinion, in turn, is a condition of default for securities, federal bailout programs and the corporate governance listing standards of the exchanges where securities must be delisted. Each of these breaches requires remediation through restatement, which, in turn, impacts earnings and enterprise values for shareholders.

Current Standards: The Code of Ethics of Sarbanes-Oxley 406, the corporate governance listing standards and the material weakness standard of the PCAOB's Auditing Standard No 5, paragraph 69, define the current standards for effective and ethical corporate governance. Effective and ethical corporate governance is defined as compliance with laws and regulations so as to prevent illegal acts per Section 10A and audit risks that qualify as termination of federal deposit insurance, a material misstatement, a material weakness, delisting of securities and a qualified audit opinion. Any violation of these compliance regulations requires remediation to restore compliance. Accountability for violations is a requirement of the Code of Ethics.

Ethics Metrics: Ethics Metrics provides independent Ethics Ratings™ on degrees of ethical and effective corporate governance for financial holding companies on compliance risks that directly impact the nation's economy, unemployment and wealth. Ethics Ratings measure and rate the full range of compliance issues that include compliance, compliance violations, the consequences of compliance violations and the required remediation of compliance violations. An executive summary of these issues is provided below:

Compliance – Ethics Ratings of 1 and 2: Ethical corporate governance is represented by Ethics Ratings of 1 and 2 for federally insured institutions and financial holding companies. Ethics Ratings of 1 and 2 signify compliance with fundamental banking and securities laws enacted after every financial crisis since 1933 with a special focus on safety and soundness regulations. Ethics Ratings 1 and 2 also represent equity securities that are not subject to material restatement risks, delisting risks and possible systemic risks, which are modern risk factors for consideration by ethical and prudent investing standards (noted below by footnotes).

Year Term: Defined in the Glossary
1830 Harvard v. Amory (Prudent Man Rule)1
1933 Material Fact
1934 Illegal Acts Per Section 10A
1934 Fraudulent Statement
1940 Investment Advisers
1948 Misrepresentation and Fraud
1948 Misleading statement, untrue material fact, SEC Rule 10(b) 5
1972 Ethical Investor, Yale2
1974 ERISA3
1977 Falsification of accounting records, Foreign Corrupt Practices Act
1988 Fraud Risk Assessment Model4
1989 Audit Risks: GAAP
1991 Safety and Soundness, CAMEL(S) Ratings 1 and 2
1991 Unsafe and unsound practices, CAMEL(S) Ratings 3, 4 and 5
1991 Well Capitalized
1991 Prompt Corrective Action
1994 COSO's Integrated Framework - Internal Controls
1994 Uniform Prudent Investor Act6
1999 Well Managed
1999 Troubled Condition, CAMELS Ratings 4 and 5, Systemic Risk
1999 Poorly Managed
1999 Financial Activities
1999 Materiality
1999 Fraudulent Financial Reporting (& Ethics) COSO; overstating asset values, Fraud SEC Rule 10(b)5; average fraud period 23.7 months3
2003 Code of Ethics
2003 Corporate Governance Listing Standards
2003 Internal Controls Over Financial Reporting (ICFR)
2003 Audit Risks: ICFR and GAAP
2003 Removal, Suspension, and Debarment of Accountants From Performing Audit Services
2004 Investment Advisers, Fiduciary Duty, Code of Ethics
2004 Material Misstatements
2004 Material Weaknesses
2004 Restatements of Material Misstatements
2008 Covenant Violations, a material misstatement
2008 Fraud, Misrepresentations and Malfeasance (Financial Firms)
2008 Fraud, Misrepresentations and Malfeasance (Regulators)
2009 Systemic Risk (See Prompt Corrective Action)
1Harvard v. Amory (Prudent Man Rule)
2The Ethical Investor, Yale University, 1972
3ERISA
4Ethical Values: Probability of financial statement fraud by Loebbecke and Willingham, 1988
5Uniform Prudent Investor Act, 1994
6Fraudulent Financial Reporting, COSO, Treadway Commission, 1999

Compliance Violations - Ethics Ratings of 3, 4 and 5: Ethics Ratings of 3, 4 and 5 represent compliance violations of the above regulations that are material misstatements and material weaknesses that have a direct and material effect on the financial statements of federally insured institutions and financial holding companies per Sarbanes-Oxley 404. Examples include:

  1. Compliance violations of safety and soundness regulations, including the well managed and well capitalized regulations, that match CAMELS Ratings of 3, 4 and 5.

  2. Systemic risk caused by firms in a troubled condition per CAMELS Ratings 4 and 5.

  3. Material facts, such as systemic risk, that qualify for disclosure to clients by the Code of Ethics and fiduciary duty of investment advisers.

Consequences of compliance violations: Major consequences of non-compliance include:

  1. Termination of federal deposit insurance.

  2. Limitations on financial activities per Section 4(k)(4) of the BHC Act, thus harming "Wall Street" activities won in the repeal of Glass-Steagall (1933) with the enactment in 1999 of Gramm-Leach-Bliley.

  3. Delisting risks of securities due to violations of corporate governance listing standards.

  4. Restatements of material misstatements and corrections of material weaknesses so as to cure underlying violations and restore compliance as a well managed and well capitalized financial holding company.

  5. Financial crises that cause grave social harm leading to deep and prolonged unemployment as well as the loss of trillions of dollars in wealth.

Required remediation of compliance violations:  Non-compliance triggers required remediation per the regulations to restore compliance. The Ethics Metrics model synchronizes compliance violations with required remediation so firms correct violations in early stages before they explode into a financial crisis and systemic risk.

Measuring and Rating Systemic Risk Through The Financial Markets:  The Ethics Metrics products and services bring transparency with independent metrics that measure and rate systemic risk as it flows through the financial market from

Management's false certifications of effective internal controls over financial reporting due to material covenant violations of illegal acts, material misstatements and material weaknesses to

Ineffective oversight of compliance and audit risks by audit committees to

Audit risks by auditors that fail to detect and disclose material illegal acts and related material misstatements and material weaknesses within fraudulent statements to

Ineffective regulatory oversight on fraud, misrepresentation and malfeasance in the offering of financial services to

Untrue material facts and misleading statements to investors to

Material facts qualifying for disclosure by investment advisers to clients based on the Code of Ethics and fiduciary obligations of the investment adviser to their client.

Measuring Risk for Uniform Prudent Investor Act (UPIC):

Background for the 1994 Uniform Prudent Investor Act: "Over the quarter century from the late 1960’s the investment practices of fiduciaries experienced significant change. The Uniform Prudent Investor Act (UPIA) undertakes to update trust investment law in recognition of the alterations that have occurred in investment practice. These changes have occurred under the influence of a large and broadly accepted body of empirical and theoretical knowledge about the behavior of capital markets, often described as "modern portfolio theory.""

The Ethics Metrics model assists in the following functions of the UPIC:

  1. Ethics Metrics measures and rates the risk of equity securities being impacted by delisting risks, restatement risks and systemic risk that impact earnings and enterprise values. This service complements the  "Prudent Investor Rule" – Section 1 per the Uniform Prudent Investor Act:

    1. "Comment. This section imposes the obligation of prudence in the conduct of investment functions and identifies further sections of the Act that specify the attributes of prudent conduct."

    2. "Origins. The prudence standard for trust investing traces back to Harvard College v. Amory, 26 Mass. (9 Pick.) 446 (1830). Trustees should "observe how men of prudence, discretion and intelligence manage their own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds, considering the probable income, as well as the probable safety of the capital to be invested." Id. at 461.

  2. Ethics Metrics assists in addressing standard of care, portfolio strategy and risk and return objectives per Section 2 of the Uniform Prudent Investor Act:

    1. "Risk and return. Subsection (b) also sounds the main theme of modern investment practice, sensitivity to the risk/return curve. See generally the works cited in the Prefatory Note to this Act, under "Literature." Returns correlate strongly with risk, but tolerance for risk varies greatly with the financial and other circumstances of the investor, or in the case of a trust, with the purposes of the trust and the relevant circumstances of the beneficiaries. A trust whose main purpose is to support an elderly widow of modest means will have a lower risk tolerance than a trust to accumulate for a young scion of great wealth."

    2. "Duty to monitor. Subsections (a) through (d) apply both to investing and managing trust assets. "Managing" embraces monitoring, that is, the trustee’s continuing responsibility for oversight of the suitability of investments already made as well as the trustee’s decisions respecting new investments."

    3. "Duty to investigate. Subsection (d) carries forward the traditional responsibility of the fiduciary investor to examine information likely to bear importantly on the value or the security of an investment – for example, audit reports or records of title. E.g., Estate of Collins, 72 Cal. App. 3d 663, 139 Cal. Rptr. 644 (1977) (trustees lent on a junior mortgage on unimproved real estate, failed to have land appraised, and accepted an unaudited financial statement; held liable for losses)."