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SECURITIES AND ~~~EXCHANGE COMMISSION i\llJ)~

Washington, D. C. 20549 .~~hJ

(202) 272.-2650 C8~gS\~

THOUGHTS ON BUSINESS ETHICS IN A PRIVATE ENTERPRISE SYSTEM

Address by

John R. EvansCommissioner

New York ChapterBrigham Young University

Management SocietyNew York, New YorkJune 21, 1982

I consider it a great honor to be with you today at thisfirst meeting of the New York Chapter of the Brigham YoungUniversity Management Society. My comments may well stimulatethought in an area that is fraught with controversy. I thinkwe would find broad agreement that the topic of this seminar,"Ethics in Business", is very important. It is important ina religious or moral sense because of the effect it can haveon the lives and goals of individuals, and in an economicsense because of the effect it can have on business andcommerce. However, due to the fact that ethics involve moralideals and goals, human motives of choice, and patterns ofright and wrong conduct, it is very difficult to reachagreement on a general definition of ethics, let alone thestandard that should be maintained in business dealings. Ibelieve the definition given by Dr. Albert Schweitzer is areasonable one. He said, "In a general sense ethics is thename we give to our concern for good behavior. We feel anobligation to consider not only our own personal well being,but also that of others and human society as a whole."

Those who have attended the Brigham Young University havebeen exposed to a high ethical standard. Because it issponsored and directed by the Church of Jesus Christ of Latter-day Saints, the BYU embodies the principles of the Church.In addition to providing an opportunity to gain knowledge insubjects that will assist students to earn a livelihood andcontribute to society in a material way, the enhancement ofethical or moral conduct in personal and business relationshipsis considered to be one of its most important purposes.

The ethical standard that is taught is contained in anArticle of Faith which in part states, "We believe in beinghonest, true, chaste, benevolent, virtuous and in doing goodto all men •••• " This is not just a concept to be discussedin religious gatherings, but part of a basic philosophy to bepracticed in all personal and business activities. The difficultquestion is, how can such a philosophy be practiced in acompetitive free enterprise economic system?

Some would argue that business activity should be basedentirely on the concept of "caveat emptor" and that marketforces of supply and demand should not be hampered by ethicalconsiderations or broad social policies because any externalrestrictions or requirements reduce the efficiency of thefree marketplace in allocating resources and producing goodsand services. Adam Smith is usually credited with being thefounder of this laissez-faire economic theory with its"invisible hand" that automatically guides the economic processto provide the greatest good for the gr~atest number. But

The views expressed herein are those of the speaker and do notnecessarily reflect the views of the Commission.

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even Adam Smith did not advocate that businessmen should seektheir personal interest to the exclusion of the publicinterest. Similarly, although I firmly believe that a compe-titive free enterprise economy is the most efficient system,it is obvious that private business activities often resultin adverse effects on public health and welfare. These costsmust be included in the price of production if resources areto be most efficiently allocated.

These observations raise several questions. Can suchcosts be voluntarily included in a competitive economic system?Isn't the prime motivation in such a system the potential forpersonal economic rewards? Are not such rewards based to asignificant degree on paying the least for the elements ofproduction and obtaining the most for goods and servicesproduced? How can business decisions based on such conceptstake into account ethical principles which would include allcosts associated with production as well as considering thewell being of others and human society as a whole? Can abusiness voluntarily include these expenses and remainprofitable if others do not also voluntarily include them?

These are not merely philosophical questions. Rather,they lead to the concrete conclusion that in a society whereeveryone does not have and practice the same ethical standards,basic standards of conduct for all must be established by anappropriate process or authority. This same concept.appliesto families, tribes, communities, states, nations and on aninternational level. In the case of private entities,including businesses and self-regulatory organizations, suchstandards become codes of ethics, rules of business practiceor self-imposed regulations. In sovereignties, standards takethe form of laws or rules and regulations that have the forceof law.

Some commentators suggest that there is a basic ethicaldifference between standards embodied in law and thoseestablished by individuals, families, religious institutions,and business or professional organizations. Although thereare important differences, I do not find distinctions on thebasis of ethics to be very meaningful. As Woodrow Wilsonstated, "The law that will work is merely the summing up inlegislative form of the moral judgment that the communityhas already reached." The enactment of an ethical standardinto law does not reduce the morality of those who wouldconform their actions to the standard in the absence of law.In a government of the people like that which we enjoy, lawsare the result of a consensus which is based on value judgmentsheld by the governed. That process usually results in legalstandards that are not as high as some believe appropriateor as low as others desire. If those who abide by the higherethical standards cease to maintain them, the very nature ofthe consensus process will result in an erosion of existing

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community standards. This being true, law cannot fullysupplant or compensate for a lack of personal ethicalstandards. Moral virtues, such as honesty, integrity, orloyalty to an ethical standard cannot be legislated.However, law can regulate behavior and it is the only prac-tical means to embody the divergent views of a pluralisticsociety into a workable framework for all. Thus, governmentregulation of business is necessary and fulfills a legitimateand beneficial function.

I believe very firmly that free market forces shouldbe permitted to operate to the maximum extent possible. Inaddition, individuals should have the opportunity and beencouraged to establish business standards for themselves,and also to participate in organizations which developindustry-wide standards. Government should be the regulatorof last resort. As the British Statesman Edmund Burkeobserved:

"Men are qualified for civil liberty in exactproportion to their disposition to put moralchains upon their own appetites. Societycannot exist unless a controlling power uponwill and appetite be placed somewhere andthe less of it there is within, the morethere is without. It is ordained in 'heeternal constitution of things that men ofintemperate minds cannot be free. Theirpassions forge their fetters."The appropriate scope of government intervention depends

on what is done by individuals and private sector organiz-ations. Indeed, the role of government should expand andcontract readily to meet changed conditions. Thus, basicregulatory statutes should not proscribe in detail, butshould establish broad goals and provide authority for aregulatory agency to deal with the details of administrationin a flexible manner under effective Congressional oversight.Providing for industry self-regulatory organizations can alsominimize government involvement and maximize the use ofindustry expertise in establishing and enforcing businessstandards. There is, however, a natural tendency for self-regulators to establish rules that protect the position ofexisting particiants contrary to the pUblic interest. Thus,government agency oversight of their rules is necessary.

One of the most efficient means of bringing about appro-priate business behavior is by requiring disclosure ofmaterial information as is done by secu'ities laws. Thisapproach enhances the operation of market forces and enablesethical beliefs of the general population to have an effecton business practices. Disclosure is more important in thislatter respect than it would have been several decades ago.

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In an earlier time when personal and business activitiestook place primarily in the local community, and were wellknown by neighbors, friends, relatives, and other closeassociates, the reputation of an individual and his businessethics were virtually inseparable. Such forces as the family,the church, and community social pressures were generallyeffective in promoting proper dealings even when personalintegrity was lacking.

However, as our society has become more complex, moretransient, and impersonal, the influence of these forces onthe conduct of individuals has declined. As business insti-tutions became national and international in scope, theiractivities became more diverse, and the actions of individualswere submerged within corporate complexes. Individualresponsibility became so diffused that, absent publicdisclosure one could engage in business conduct which was notsocially acceptable without being personally accountable tosociety for his actions.

Disclosure of material business information providesinvestors with the opportunity to refrain from investing infirms that engage in activities with which they do not agree.In addition, disclosure has the effect of discouragingpractices that are not in accord with accepted ethicalstandards.

It has been argued that the SEC improperly uses itsdisclosure authority to establish ethical standards for publiccorporations. Naturally, members of the Securities andExchange Commission have our own personal ethical standards,but we are not authorized to impose them on businesses. Ourdecisions must be based on provisions of law which we havethe authority and responsiblity to administer and courtdecisions interpreting that law.

Among other things, securities laws authorize theCommission to require the disclosure of information necessaryto carry out the purposes contained therein, and to adoptrules as necessary or appropriate in the public interest orfor the protection of investors. The purposes referred toare generally to provide full and fair disclosure of thecharacter of securities, to prevent frauds in the sale thereofto provide for the regulation of securities markets and toprevent inequitable and unfair practices in those markets.

As might be expected, there are those whothe Commission to use its disclosure authorityall statutes that are applicable to business.Commission has stated its position that:

would liketo help enforceHowever, the

"the discretion vested in the Commission underthe Securities Act and the Securities ExchangeAct to require disclosure which is necessary

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or appropriate in the 'public interest' doesnot generally permit the Commission to requiredisclosure for the sole purpose of promotingsocial goals unrelated to those underlyingthese Acts."

This position does not, of course, restrict the Commissionfrom requiring disclosure that has an effect on corporateconduct. The Commission may specifically require thedisclosure of any information that meets the broad standardsI have described.

In the absence of a specific requirement, publiccorporations must disclose all "material information", whichhas been defined as that information which a reasonable personwould consider important in making an investment or corporatesuffrage decision. In other words, disclosure generally isrequired if there is a substantial likelihood that it wouldbe viewed by a reasonable investor as significantly alteringthe "total mix" of available information. Information maybe "quantitatively" or "qualitatively" material. It isquantitatively material if it has economic significance to acorporation's business. For example, a SIO million expenseitem normally would not be quantitatively material to Exxonbecause of the size of its operations. The same expense,however, would be material to a company whose total annualsales are SIOO million. Information may be qualitativelymaterial if it is relevant to the competency or the integrityof management. This could include such things as the integrityof a company's books and records, the adequacy of its accountingsystem, and questionable or illegal activities of management.Determining Whether information is material under either ofthese standards often requires difficult judgments of thoseconsidering whether disclosure is required. It must be obviousthat because qualitative materiality deals with factors thatare harder to measure, such as competence and integrity, itis much more difficult to determine.

Despite the fact that the law with respect to qualitativemateriality is unsettled, many investors consider the qualityof management to be the most important factor in theirdecisionmaking. For instance, some court cases have held thatshareholders are entitled to a truthful presentation ofinformation impugning the honesty, loyalty or competency ofthose who have a fiduciary duty in their corporate activities,and that because of the relationship of questionable orillegal payments to the integrity of management, such paymentsmust be disclosed.

Everything relating to management, however, is not equallyimportant. Courts have generally held that adjudicatedillegal acts by management in their corporate capacity must bedisclosed because they are material to managements' integrity.Generally courts have also required disclosure of lawsuits

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which are merely pending against directors and officers ifthey allege serious illegal acts. However, one court deemeda very serious adjudicated crime, bank robbery, not to be amaterial matter required to be disclosed because it occurredsufficiently long ago. And some courts have not requireddisclosure of serious corporate misconduct by management whensuch action has not been adjudicated to be illegal. Forinstance, in a 1979 case, a court in the Southern Districtof New York concluded that unless there are affirmativestatements as to its integrity, management is not required todisclose certain antisocial or illegal policies.

Reports by the news media that this last approach isshared by some members of the Commission staff have causedpublic concern. One statement attributed to an internal staffmemorandum to the Commission was that "it would be inappropriateto allege disclosure violations based on unadjudicated illegalor improper conduct by a company's officers and directorsunless there were affirmative representations as to managements'honesty and integrity in some document." According to thisview,' there is no implied representation of management integrityrunning to the market which would be rendered misleading bythe failure to disclose illegal or unethical conduct bymanagement. I want to make it clear that this is not a viewheld by all of our staff nor is it an official Commissionposition. Indeed, although this is a very difficult areawith important ramifications, I cannot readily accept theconcept that there is no implied representation of managementhonesty or integrity. In order to adopt this concept, I wouldhave to believe, as some critics of the SEC assert theCommission does believe, that businessmen are dishonest orantisocial or that corporations are essentially immoral.But in my opinion, most business men and women are honestand law abiding and expect the same of others.

I believe that honesty and compliance with law are funda-mental principles upon which all business and otherrelationships in a free society are based. When a law isenacted, it establishes a standard which by definition appliesto everyone within its scope. As Theodore Roosevelt stated,"No man is above the law and no man is below it; nor do weask any man's permission when we require him to obey it."Thus, there is no need for anyone to represent explicitly orimplicitly that laws are applicable to him. If some kind ofrepresentation is thought to be necessary, rather thansuggesting that management should not be held accountable todisclose illegal acts unless there is an affirmative represen-tation as to its honesty and integrity, it would seem moreappropriate that management be held accountable unless thereis a prior negative representation as to its honesty andintegrity.

In conclusion, let me share with you some of the commentsthe Commission has received in response to the statements

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which the press attributed to some of our staff. One personwrote:

"I have been a commercial banker for 27 yearsmainly because I have always believed thathonesty and integrity are the very heart ofthe foundation of banking. For the SEC tonow condone and advocate unlawful behavior bya bank as reasonable and standard businessjUdgment is a flagrant and irresponsible actof either disdain or ignorance.

You have done an immense disservice to thepublic as well. Our industry does not needthis kind of false and damaging publicity."

A letter from a businessman stated:

"I find it hard to believe that someoneemployed by the SEC could have said thatcorporations had minimal obligations todisclose illegal conduct where management hadnever represented that it had 'honesty andintegrity.' Please say that no one wrote this.Otherwise, criminals who had never representedthemselves as being honest and having integrity'could be judged to be innocent of wrongdoing.'

I'm part of management of my company. I wasnever asked to represent myself as being honestyet I'm sure that I'm expected to be honest.Or am I wrong about that? Should I considerbeing evasive and immoral when I next transacta deal for my company since the SEC would holdmy firm harmless?"

A law professor wrote:

"[I]t really is striking to see laid out in blackand white what is usually said explicitly only byeconomists (and Marxists), that there is noobligation to obey the law in a market-based society,and to see it said by, inter alia, the Office ofGeneral Counsel, the lawyers. It makes ratherdifficult any sort of preaching to people engagedin welfare fraud, shoplifting, or long distancetelephoning through fictitious billing, don't youthink? • • •

A company that violates tax and exchange controlregulations is not a bad corporation. It is notto be thought that anyone is actually implyingthat officers and directors of [the company] arepeople of honesty and integrity. Management

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made a reasonable business judgment in takingthe most profitable course despite the knowledgethat it was probably unlawful. The thing to dois to try to get away with it."

Finally, a television commentator said:

"According to a published report, which sourcestell me is on the mark, the commission seesnothing wrong with companies breaking the law,and it won't insist that corporate managers behonest.

Quoting from documents, the story says that, since[the company's] management had never claimedhonesty and integrity, it had no duty to say whenit was being honest. And transferring money,in violation of the law, was, according to thecommission, reasonable and standard businessjUdgment.

Sources at the SEC say that the case was just amatter of law ••• that the Commission didn'tthink it had the authority to sue [the company].But the Commission has also set up new guideposts,which every corporate manager is going to studyvery closely. And it won't do anybody any good• • • not the stock market, not investors, noteven company managers. And to happen at the crownjewel of Washington's agencies. Well, it's just ashame."

It is important to remember that none of the statementsreferred to in the press and in these responses are attributableto members of the Commission, nor have they been adopted asCommission policy. Moreover, the letters fail to address sometough legal questions. Nevertheless, these and other commentsreceived do indicate serious concern. Whether such views arerepresentative of public opinion, with respect to disclosurepolicy, I don't know. Certainly, careful thought and analysisis required to resolve these issues.