Pomerantz LLP

Misrepresentations About Company Ethics Policies Should Be Actionable

Attorney: Louis C. Ludwig
Pomerantz Monitor November/December 2017

At the recent Annual Institute for Investor Protection Conference held in Chicago, Professor Ann Olazabal of the University of Miami proposed a heightened emphasis on the enforcement of corporate codes of ethics. While this seems like basic common sense, courts in securities class actions have often seen things quite differently, and have repeatedly characterized statements about company codes of conduct as little more than inactionable PR fluff. Fortunately for investors, a countervailing judicial (and regulatory) trend of accountability has emerged, and may yet imbue corporate codes of ethics with the robust prophylactic function envisioned by Professor Olazabal.

To plead a claim under Section 10(b)(5) of the Securities Exchange Act of 1934, a plaintiff must allege that defendants made a material misrepresentation or omission in connection with the purchase or sale of a security, either intentionally or recklessly. Because so many well-known corporate scandals have been the product of serious ethical lapses, it should be actionable that a company chooses to speak falsely about its adherence to internal ethical standards in investor-targeted communications. Yet courts have proven reluctant to permit cases alleging precisely such facts to move forward.

The Ninth Circuit’s decision in Retail Wholesale & Department Store Union Local 338 Retirement Fund v. Hewlett-Packard Co. and Mark A. Hurd provides a prime example. In that case, following a 2006 ethics scandal in which it was revealed that HP had hired detectives to spy on directors, employees and journalists, the company had revised and strengthened its ethics code, or “Standards of Business Conduct” (“SBC”). In 2010, this purported strengthening was put to the test when it was revealed that Mark Hurd, HP’s then- CEO and Chairman, had sexually harassed an HP contractor and falsified expense reports to hide the relationship. In the press release disclosing Hurd’s resignation, HP admitted that Hurd knowingly violated the SBC and acted unethically. HP’s stock plummeted in response to the announcement of Hurd’s resignation, resulting in a $10 billion loss in market capitalization.

Investors filed suit, alleging misrepresentations in the form of HP’s statements about its ethics, which were inconsistent with Hurd’s conduct, or, alternately, material omissions regarding Hurd’s unethical behavior, which plaintiffs claimed HP had a duty to disclose. The district court dismissed, and the Ninth Circuit affirmed, holding, as an issue of first impression, that HP’s ethics-related representations were neither false nor material, and that the plaintiffs had failed to make out a prima facie claim under the Exchange Act.

First, the Ninth Circuit held that HP and Hurd had made no “objectively verifiable” statements regarding HP’s compliance with the SBC. Instead, the HP court described the SBC statements about it as “inherently aspirational” and therefore not “capable of being objectively false.” The court also concluded that “the aspirational nature of these statements is evident. They emphasize a desire to commit to certain “shared values” outlined in the SBC and provide a “vague statement[ ] of optimism,” not capable of objective verification.” Second, the panel found that HP’s ethical representations were not material because companies are required by the SEC to publish their codes of conduct, and that “it simply cannot be that a reasonable investor’s decision could conceivably have been affected by HP’s compliance with SEC regulations requiring publication of ethics standards.” Third, the court rejected allegations that HP and Hurd misled by omission, reiterating the view that these were “transparently aspirational” statements lacking any ironclad guarantee that nobody at HP would ever violate the SBC. In sum, HP outlines a vision of corporate ethics that is strikingly cynical. Indeed, it might even be asked why the SEC requires that codes of conduct be published if corporations do not believe them, while investors cannot believe them.

While HP drastically limits the circumstances under which a corporate defendant’s noncompliance with its code of ethics gives rise to actionable misrepresentations and omissions under the Exchange Act, there are some silver linings. Around the same time that the HP decision issued, the SEC imposed a $2.4 million fine against United Airlines’ parent company for violating the Exchange Act’s accounting provisions when its CEO failed to follow anti-corruption and anti-bribery procedure. Specifically, the airline had secured approval from the Port Authority of New York and New Jersey to build a maintenance hangar at the Newark Airport in exchange for reopening and operating a previously-closed route for the sole purpose of ferrying the Port Authority chairman to and from his home in South Carolina. The route was referred to internally as the “Chairman’s Flight” in an express nod to the bribery underlying its existence.

The SEC’s action against the company relied in large part on code-of-conduct provisions prohibiting bribery and requiring that any waivers from compliance with the code be both brought before the board of directors and publicly disclosed. There was no record that the relevant permission was obtained or the relevant disclosures made. Based on this misconduct, the United States Department of Justice entered into a nonprosecution agreement with United that mandated the airline’s development of a rigorous anti-bribery and anti-corruption compliance program. And because, as the HP experience proves, rules do not enforce themselves, U nited was also compelled to review the new policies at least annually and update the Justice Department as necessary to address developments in the field, as well as evolving international and industry standards. Perhaps most critically, United was required to designate an executive to be responsible for the oversight and implementation of these codes, policies, and procedures, and to report on them to the board of directors.

While private litigants unquestionably lack the enforcement muscle of the SEC, the United episode underscores that institutional change can emanate from a renewed focus on code-of-ethics compliance. The ironic challenge for securities fraud plaintiffs is how to spur that focus while the answer – deterrence through increased litigation – is in plain sight. To this end, some district courts have allowed claims premised on codes of ethics to move forward. They have done so by treating the content of ethical codes not as “aspirational” but as a representation of the state-of-affairs on the ground.

For example, in In re Petrobras Sec. Litig., in which Pomerantz is lead counsel, the court upheld a complaint alleging misrepresentations based on the defendant company’s claims that it had “established a commission ‘aimed at assuring the highest ethical standards,’ … that it ‘adopts the best corporate governance practices,’ … that it undertook to ‘conduct its business with transparency and integrity’ and .… that it was ‘fully committed to implementing a fair and transparent operation.’” More recently, the court in In re Eletrobras Sec. Litig. held that the company’s “repeated assertions about its strong ethical standards stand in stark contrast” with subsequently- disclosed criminal activities, and that therefore actionable misrepresentations had been alleged. It remains to be seen whether these cases or the more skeptical view on display in HP will dominate the landscape going forward, but it stands to reason that where a company’s public, ethical face is little more than a mask, investors will continue to be deceived about what  lies beneath.