6 Corporate Governance and Sarbanes-Oxley Act and Other Recent Reforms

What Is Corporate Governance?

The tug of war between individual freedom and institutional power is a continuing theme of history. Early on, the focus was on the church; more recently, it is on the civil state. Today, the debate is about making corporate power compatible with the needs of a democratic society. The modern corporation has not only created untold wealth and given individuals the opportunity to express their genius and develop their talents but also has imposed costs on individuals and society. How to encourage the liberation of individual energy without inflicting unacceptable costs on individuals and society, therefore, has emerged as a key challenge.

Corporate governance lies at the heart of this challenge. It deals with the systems, rules, and processes by which corporate activity is directed. Narrow definitions focus on the relationships between corporate managers, a company’s board of directors, and its shareholders. Broader descriptions encompass the relationship of the corporation to all of its stakeholders and society, and cover the sets of laws, regulations, listing rules, and voluntary private-sector practices that enable corporations to attract capital, perform efficiently, generate profit, and meet both legal obligations and general societal expectations. The wide variety of definitions and descriptions that have been advanced over the years also reflect their origin: lawyers tend to focus on the contractual and fiduciary aspects of the governance function; finance scholars and economists think about decision-making objectives, the potential for conflict of interest, and the alignment of incentives, while management consultants tend to adopt a more task-oriented or behavioral perspective.

Complicating matters, different definitions also reflect two fundamentally different views about a corporation’s purpose and responsibilities. Often referred to as the “shareholder versus stakeholder” perspectives, they define a debate about whether managers should run a corporation primarily or solely in the interests of its legal owners—the shareholders (the shareholder perspective)—or whether they should actively concern themselves with the needs of other constituencies (the stakeholder perspective).

This question is answered differently in different parts of the world. In Continental Europe and Asia, for example, managers and boards are expected to concern themselves with the interests of employees and the other stakeholders, such as suppliers, creditors, tax authorities, and the communities in which they operate. Reflecting this perspective, the Centre of European Policy Studies (CEPS) defines corporate governance as “the whole system of rights, processes and controls established internally and externally over the management of a business entity with the objective of protecting the interests of all stakeholders.”1 In contrast, the Anglo-American approach to corporate governance emphasizes the primacy of ownership and property rights and is primarily focused on creating “shareholder” value. In this view, employees, suppliers, and other creditors have rights in the form of contractual claims on the company, but as owners with property rights, shareholders come first:

Corporate governance is the system by which companies are directed and controlled. Boards of directors are responsible for the governance of their companies. The shareholders’ role in governance is to appoint the directors and the auditors and to satisfy themselves that an appropriate governance structure is in place.2

Perhaps the broadest, and most neutral, definition is provided by the Organization for Economic Cooperation and Development (OECD), an international organization that brings together the governments of countries committed to democracy and the market economy to support sustainable economic growth, boost employment, raise living standards, maintain financial stability, assist other countries’ economic development, and contribute to growth in world trade:

Corporate governance is the system by which business corporations are directed and controlled. The corporate governance structure specifies the distribution of rights and responsibilities among different participants in the corporation, such as, the board, managers, shareholders and other stakeholders, and spells out the rules and procedures for making decisions on corporate affairs. By doing this, it also provides the structure through which the company objectives are set, and the means of attaining those objectives and monitoring performance.3

Corporate Governance: Linking Corporations and Society

The U.S. Corporate Governance System

Today’s U.S. corporate governance system is best understood as the set of fiduciary and managerial responsibilities that binds a company’s management, shareholders, and the board within a larger, societal context defined by legal, regulatory, competitive, economic, democratic, ethical, and other societal forces.


Although shareholders own corporations, they usually do not run them. Shareholders elect directors, who appoint managers who, in turn, run corporations. Since managers and directors have a fiduciary obligation to act in the best interests of shareholders, this structure implies that shareholders face two separate so-called principal-agent problems—with management whose behavior will likely be concerned with its own welfare, and with the board, which may be beholden to particular interest groups, including management.[1] Many of the mechanisms that define today’s corporate governance system are designed to mitigate these potential problems and align the behavior of all parties with the best interests of shareholders broadly construed.

The notion that the welfare of shareholders should be the primary goal of the corporation stems from shareholders’ legal status as residual claimants. Other stakeholders in the corporation, such as creditors and employees, have specific claims on the cash flows of the corporation. In contrast, shareholders get their return on investment from the residual only after all other stakeholders have been paid. Theoretically, making shareholders residual claimants creates the strongest incentive to maximize the company’s value and generates the greatest benefits for society at large.

Not all shareholders are alike and share the same goals. The interests of small (minority) investors, on the one hand, and large shareholders, including those holding a controlling block of shares and institutional investors, on the other, are often different. Small investors, holding only a small portion of the corporation’s outstanding shares, have little power to influence the board of the corporation. Moreover, with only a small share of their personal portfolios invested in the corporation, these investors have little motivation to exercise control over the corporation. As a consequence, small investors are usually passive and interested only in favorable returns. They often do not even bother to vote; they simply sell their shares if they are not satisfied.

In contrast, large shareholders often have a sufficiently large stake in the corporation to justify the time and expense necessary to monitor management actively. They may hold a controlling block of shares or be institutional investors, such as mutual funds, pension plans, employee stock ownership plans, or—outside the United States—banks whose stake in the corporation may not qualify as majority ownership but is large enough to motivate active engagement with management.

It should be noted that the term “institutional investor” covers a wide variety of managed investment funds, including banks, trust funds, pension funds, mutual funds, and similar “delegated investors.” All have different investment objectives, portfolio management disciplines, and investment horizons. As a consequence, institutional investors both represent another layer of agency problems and opportunity for oversight. To identify the potential for an additional layer of agency problems, ask why we should expect that a bank or pension fund will look out for minority shareholder interests any better than corporate management. On the one hand, institutional investors may have “purer” motives than management— principally a favorable investment return. On the other hand, they often make for passive, indifferent monitors, partly out of preference and partly because active monitoring may be prohibited by regulations or by their own internal investment rules. Indeed, a major tenet of the recent governance debate is focused on the question of whether it is useful and desirable to create ways for institutional investors to take a more active role in monitoring and disciplining corporate behavior. In theory, as large owners, institutional investors have a greater incentive to monitor corporations. Yet, the reality is that institutions failed to protect their own investors from managerial misconduct in firms like Enron, Tyco, Global Crossing, and WorldCom, even though they held large positions in these firms.

The latest development in the capital markets is the rise of private equity. Private equity funds differ from other types of investment funds mainly in the larger size of their holdings in individual investee companies, their longer investment horizons, and the relatively fewer number of companies in individual fund portfolios. Private equity managers typically have a greater degree of involvement in their investee companies compared to other investment professionals, such as mutual fund or hedge fund managers, and play a greater role in influencing the corporate governance practices of their investee companies. By virtue of their longer investment horizon, direct participation on the board, and continuous engagement with management, private equity managers play an important role in shaping governance practices. That role is even stronger in a buyout or majority stake acquisition, where a private equity manager exercises substantial control—not just influence as in minority stake investments—over a company’s governance. Not surprisingly, scholars and regulators are keeping a close watch on the impact of private equity on corporate performance and governance.

State and Federal Law

Until recently, the U.S. government relied on the states to be the primary legislators for corporations. Corporate law primarily deals with the relationship between the officers, board of directors, and shareholders, and therefore traditionally is considered part of private law. It rests on four key premises that define the modern corporation: (a) indefinite life, (b) legal personhood, (c) limited liability, and (d) freely transferable shares. A corporation is a legal entity consisting of a group of persons—its shareholders—created under the authority of the laws of a state. The entity’s existence is considered separate and distinct from that of its members. Like a real person, a corporation can enter into contracts, sue and be sued, and must pay tax separately from its owners. As an entity in its own right, it is liable for its own debts and obligations. Providing it complies with applicable laws, the corporation’s owners (shareholders) typically enjoy limited liability and are legally shielded from the corporation’s liabilities and debts. [2]

The existence of a corporation is not dependent upon whom the owners or investors are at any one time. Once formed, a corporation continues to exist as a separate entity, even when shareholders die or sell their shares. A corporation continues to exist until the shareholders decide to dissolve it or merge it with another business. Corporations are subject to the laws of the state of incorporation and to the laws of any other state in which the corporation conducts business. Corporations may therefore be subject to the laws of more than one state. All states have corporation statutes that set forth the ground rules as to how corporations are formed and maintained.

A key question that has helped shape today’s patchwork of corporate laws asks, “What is or should be the role of law in regulating what is essentially a private relationship?” Legal scholars typically adopt either a “contract-based” or “public interest” approach to this question. Free-market advocates tend to see the corporation as a contract, a voluntary economic relationship between shareholders and management, and see little need for government regulation other than the necessity of providing a judicial forum for civil suits alleging breach of contract. Public interest advocates, on the other hand, concerned by the growing impact of large corporations on society, tend to have little faith in market solutions and argue that government must force firms to behave in a manner that advances the public interest. Proponents of this point of view focus on how corporate behavior affects multiple stakeholders, including customers, employees, creditors, the local community, and protectors of the environment.

The stock market crash of 1929 brought the federal government into the regulation of corporate governance for the first time. President Franklin Roosevelt believed that public confidence in the equity market needed to be restored. Fearing that individual investors would shy away from stocks and, by doing so, reduce the pool of capital available to fuel economic growth in the private sector, Congress enacted the Securities Act in 1933 and the Securities Exchange Act in the following year, which established the Securities and Exchange Commission (SEC). This landmark legislation shifted the balance between the roles of federal and state law in governing corporate behavior in America and sparked the growth of federal regulation of corporations at the expense of the states and, for the first time, exposed corporate officers to federal criminal penalties. More recently, in 2002, as a result of the revelations of accounting and financial misconduct in the Enron and WorldCom scandals, Congress enacted the Accounting Reform and Investor Protection Act, better known as the Sarbanes-Oxley Act.

Most of the major state court decisions involving corporate governance are issued by the Delaware Chancery Court, due to the large number of major corporations incorporated in Delaware. In the 21st century, federal securities law, however, has supplanted state law as the most visible means of regulating corporations. The federalization of corporate governance law is perhaps best illustrated by the provision of the Sarbanes-Oxley law that bans corporate loans to directors and executive officers, a matter long dominated by state law.

The Securities and Exchange Commission

The SEC—created to protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation—is charged with implementing and enforcing the legal framework that governs security transactions in the United States. This framework is based on a simple and straightforward concept: All investors, whether large institutions or private individuals, should have access to certain basic facts about an investment prior to buying it, and so long as they hold it. To achieve this, the SEC requires public companies to disclose meaningful financial and other information to the public. This promotes efficiency and transparency in the capital market, which, in turn, stimulates capital formation. To ensure efficiency and transparency, the SEC monitors the key participants in the securities trade, including securities exchanges, securities brokers and dealers, investment advisers, and mutual funds. [3]

Crucial to the SEC’s effectiveness in each of these areas is its enforcement authority. Each year the SEC brings hundreds of civil enforcement actions against individuals and companies for violation of the securities laws. Typical infractions include insider trading, accounting fraud, and providing false or misleading information about securities and the companies that issue them. Although it is the primary overseer and regulator of the U.S. securities markets, the SEC works closely with many other institutions, including Congress, other federal departments and agencies, self-regulatory organizations (e.g., the stock exchanges), state securities regulators, and various private sector organizations. Specific responsibilities of the SEC include (a) interpret federal securities laws; (b) issue new rules and amend existing rules; (c) oversee the inspection of securities firms, brokers, investment advisers, and ratings agencies; (d) oversee private regulatory organizations in the securities, accounting, and auditing fields; and (e) coordinate U.S. securities regulation with federal, state, and foreign authorities.

The Exchanges

The NYSE Euronext and NASDAQ account for the trading of a major portion of equities in North America and the world. While similar in mission, they are different in the ways they operate and in the types of equities that are traded on them. [4]

The NYSE Euronext and its predecessor, the NYSE, trace their origins to 1792. Their listing standards are among the highest of any market in the world. Meeting these requirements signifies that a company has achieved leadership in its industry in terms of business and investor interest and acceptance. The Corporate Governance Listing Standards set out in Section 303A of the NYSE Listed Company Manual were initially approved by the SEC on November 4, 2003, and amended in the following year. Today, NYSE Euronext’s nearly 4,000 listed companies represent almost $30 trillion in total global market capitalization.

The NASDAQ, the other major U.S. stock exchange, is the largest U.S. electronic stock market. With approximately 3,200 companies, it lists more companies and, on average, trades more shares per day than any other U.S. market. It is home to companies that are leaders across all areas of business, including technology, retail, communications, financial services, transportation, media, and biotechnology. The NASDAQ is typically known as a high-tech market, attracting many of the firms dealing with the Internet or electronics. Accordingly, the stocks on this exchange are considered to be more volatile and growth-oriented.

While all trades on the NYSE occur in a physical place, on the trading floor of the NYSE, the NASDAQ is defined by a telecommunications network. The fundamental difference between the NYSE and NASDAQ, therefore, is in the way securities on the exchanges are transacted between buyers and sellers. The NASDAQ is a dealer’s market in which market participants buy and sell from a dealer (the market maker). The NYSE is an auction market, in which individuals typically buy from and sell to one another based on an auction price.

Prior to March 8, 2006, a major difference between these two exchanges was their type of ownership: the NASDAQ exchange was listed as a publicly traded corporation, while the NYSE was private. In March of 2006, however, the NYSE went public after being a not-for-profit exchange for nearly 214 years. In the following year, NYSE Euronext—a holding company—was created as part of the merger of the NYSE Group Inc. and Euronext N.V. Now, NYSE Euronext operates the world’s largest and most liquid exchange group and offers the most diverse array of financial products and services (see NYSE Web site at http://www.nyse.com). It brings together six cash equities exchanges in five countries and six derivatives exchanges and is a world leader for listings, trading in cash equities, equity and interest rate derivatives, bonds, and the distribution of market data. As publicly traded companies, the NASDAQ and the NYSE must follow the standard filing requirements set out by the SEC and maintain a body of rules to regulate their member organizations and their associated persons. Such rules are designed to prevent fraudulent and manipulative acts and practices, promote just and equitable principles of trade, and provide a means by which they can take appropriate disciplinary actions against their membership when rule violations occur.

The Gatekeepers: Auditors, Security Analysts, Bankers, and Credit Rating Agencies

The integrity of our financial markets greatly depends on the role played by a number of “gatekeepers”— external auditors, analysts, and credit rating agencies—in detecting and exposing the kinds of questionable financial and accounting decisions that led to the collapse of Enron, WorldCom, and other “misreporting” or accounting frauds. [5] A key question is whether we can (or should) rely on these gatekeepers to perform their roles diligently. It can be argued that we can and should because their business success depends on their credibility and reputation with the ultimate users of their information— investors and creditors—and if they provide fraudulent or reckless opinions, they are subject to private damage suits. The problem with this view is that the interests of gatekeepers are often more closely aligned with those of corporate managers than with investors and shareholders. Gatekeepers, after all, are typically hired and paid (and fired) by the very firms that they evaluate or rate, and not by creditors or investors. Auditors are hired and paid by the firms they audit; credit rating agencies are typically retained and paid by the firms they rate; lawyers are paid by the firms that retain them; and, as we learned in the aftermath of the 2001 governance scandals, until recently the compensation of security analysts (who work primarily for investment banks) was closely tied to the amount of related investments banking business that their employers (the investment banks) do with the firms that their analysts evaluate. [6] A contrasting view, therefore, holds that most gatekeepers are inherently conflicted and cannot be expected to act in the interests of investors and shareholders. Advocates of this perspective also argue that gatekeeper conflict of interest worsened during the 1990s because of the increased cross-selling of consulting services by auditors and credit rating agencies and by the cross-selling of investment banking services. [7] Both issues are addressed by recent regulatory reforms; new rules address the restoration of the “Chinese Wall” between investment banks and security analysts, and mandate the separation of audit and consulting services for accounting firms.

[1] Agency theory explains the relationship between principals, such as shareholders and agents, like a company’s executives. In this relationship, the principal delegates or hires an agent to perform work. The theory attempts to deal with two specific problems: first, that the goals of the principal and agent are not in conflict (agency problem) and second, that the principal and agent reconcile different tolerances for risk.

[2] This section is based on Kenneth Holland’s May 2005 review of the book Corporate Governance: Law, Theory and Policy.

[3] http://www.sec.gov/about/whatwedo.shtml

[4] http://www.investopedia.com

[5] This section draws on Edwards (2003).

[6] Citigroup paid $400 million to settle government charges that it issued fraudulent research reports; and Merrill Lynch agreed to pay $200 million for issuing fraudulent research in a settlement with securities regulators and also agreed that, in the future, its securities analysts would no longer be paid on the basis of the firm’s related investment-banking work.

[7] Coffee (2002, 2003a, 2003b).

Corporate Governance in America: A Brief History Entrepreneurial, Managerial, and Fiduciary Capitalism

In the first part of the twentieth century, large U.S. corporations were controlled by a small number of wealthy entrepreneurs—Morgan, Rockefeller, Carnegie, Ford, and Du Pont, to name a few. These “captains of industry” not only owned the majority of the stock in companies, such as Standard Oil and U.S. Steel, but they also exercised their rights to run these companies. By the 1930s, however, the ownership of U.S. corporations had become much more widespread. Capitalism in the United States had made a transition from entrepreneurial capitalism, the model in which ownership and control had been synonymous, to managerial capitalism, a model in which ownership and control were effectively separated—that is, in which effective control of the corporation was no longer exercised by the legal owners of equity (the shareholders) but by hired, professional managers. With the rise of institutional investing in the 1970s, primarily through private and public pension funds, the responsibility of ownership became once again concentrated in the hands of a relatively small number of institutional investors who act as fiduciaries on behalf of individuals. This large-scale institutionalization of equity brought further changes to the corporate governance landscape. Because of their size, institutional investors effectively own a major fraction of many large companies. And because this can restrict their liquidity, they de facto may have to rely on active monitoring (usually by other, smaller activist investors) than trading. This model of corporate governance, in which monitoring has become as or more important than trading, is sometimes referred to as fiduciary capitalism. [1]

The 1980s: Takeovers and Restructuring

As the ownership of American companies changed, so did the board-management relationship. For the greater part of the 20th century, when managerial capitalism prevailed, executives had a relatively free rein in interpreting their responsibilities toward the various corporate stakeholders and, as long as the corporation made money and its operations were conducted within the confines of the law, they enjoyed great autonomy. Boards of directors, mostly selected and controlled by management, intervened only infrequently, if at all. Indeed, for the first half of the last century, corporate executives of many publicly held companies managed with little or no outside control. Saylor URL: http://www.saylor.org/books Saylor.org 22

In the 1970s and 1980s, however, serious problems began to surface, such as exorbitant executive payouts, disappointing corporate earnings, and ill-considered acquisitions that amounted to little more than empire building and depressed shareholder value. Led by a small number of wealthy, activist shareholders seeking to take advantage of the opportunity to capture underutilized assets, takeovers surged in popularity. Terms, such as leveraged buyout, dawn raids, poison pills, and junk bonds, became household words, and individual corporate raiders, including Carl Icahn, Irwin Jacobs, and T. Boone Pickens, became well known. The resulting takeover boom exposed under performing companies and demonstrated the power of unlocking shareholder value.

The initial response of U.S. corporate managers was to fight takeovers with legal maneuvers and to attempt to enlist political and popular support against corporate raiders. These efforts met with some legislative, regulatory, and judicial success and made hostile takeovers far more costly. As a result, capital became scarce and junk-bond-financed, highly leveraged, hostile takeovers faded from the stage. [2] Of lasting importance from this era was the emergence of institutional investors who knew the value of ownership rights, had fiduciary responsibilities to use them, and were big enough to make a difference. [3] And with the implicit assent of institutional investors, boards substantially increased the use of stock option plans that allowed managers to share in the value created by restructuring their own companies. Shareholder value, therefore, became an ally rather than a threat. [4] [1] This section is based on the essay by Hawley and Williams (2001). [2] Thornton (2002, January 14). Hostile takeovers made a dramatic comeback after the 2001 to 2002 economic recession. In 2001, the value of hostile takeovers climbed to $94 billion, more than twice the value in 2000 and almost $15 billion more than in 1988, the previous peak year. [3] Romano (1994). [4] Holmstrom and Kaplan (2003). Saylor URL: http://www.saylor.org/books Saylor.org 23

The Meltdown of 2001

The year 2001 will be remembered as the year of corporate scandals. The most dramatic of these occurred in the United States—in companies such as Enron, WorldCom, Tyco, and others—but Europe also had its share, with debacles at France’s Vivendi, the Netherlands’ Ahold, Italy’s Parmalat, and ABB, a Swiss-Swedish multinational company. Even before these events fully unfolded, a rising number of complaints about executive pay, concerns about the displacement of private-sector jobs to other countries through off-shoring, and issues of corporate social responsibility had begun to fuel emotional and political reactions to corporate news in the United States and abroad.

Most of these scandals involved deliberately inflating financial results, either by overstating revenues or understating costs, or diverting company funds to the private pockets of managers. Two of the most prominent examples of fraudulent “earnings management” include Enron’s creation of off– balance sheet partnerships to hide the company’s deteriorating financial position and to enrich Enron executives and WorldCom’s intentional misclassification of as much as $11 billion in expenses as capital investments—perhaps the largest accounting fraud in history.

The Enron scandal came to symbolize the excesses of corporations during the long economic boom of the 1990s. [1] Hailed by Fortune magazine as “America’s Most Innovative Company” for 6 straight years from 1996 to 2001, Enron became one of the largest bankruptcies in U.S. history. Its collapse in December 2001 followed the disclosure that it had reported false profits, using accounting methods that failed to follow generally accepted procedures. Both internal and external controls failed to detect the financial losses disguised as profits for a number of years. At first, Enron’s senior executives, whose activities brought the company to the brink of ruin, escaped with millions of dollars as they retired or sold their company stock before its price plummeted. Enron employees were not so lucky. Many lost their jobs and a hefty portion of retirement savings invested in Enron stock. Because the company was able to hide its losses for nearly 5 years, the Enron scandal shook the confidence of investors in American governance around the world. Outside agencies, such as accounting firms, credit rating businesses, and stock market analysts had failed to warn the public Saylor URL: http://www.saylor.org/books Saylor.org 24 about Enron’s business losses until they were obvious to all. Internal controls had not functioned, either. And Enron’s board of directors, especially its audit committee, apparently did not understand the full extent of the financial activities undertaken by the firm and, consequently, had failed in providing adequate oversight. Some experts believed that the federal government also bore some responsibility. Politicians in both the legislative and executive branches received millions of dollars in campaign donations from Enron during the period when the federal government decided to deregulate the energy industry, removing virtually all government controls. Deregulation was the critical act that made Enron’s rise as a $100 billion company possible.

In June 2002, shortly after the Enron debacle, WorldCom admitted that it had falsely reported $3.85 billion in expenses over 5 quarterly periods to make the company appear profitable when it had actually lost $1.2 billion during that period. [2] Experts said it was one of the biggest accounting frauds ever. In its aftermath, the company was forced to lay off about 17,000 workers, more than 20% of its workforce. Its stock price plummeted from a high of $64.50 in 1999 to 9 cents in late July 2002 when it filed for bankruptcy protection. In March 2004, in a formal filing with the SEC, the company detailed the full extent of its fraudulent accounting. The new statement showed the actual fraud amounted to $11 billion and was accomplished mainly by artificially reducing expenses to make earnings appear larger. After restructuring its debt and meeting other requirements imposed by a federal court, the company emerged from bankruptcy protection in April 2004 and formally changed its name to MCI Inc. Even as it emerged from bankruptcy, industry observers anticipated that MCI would need to merge with another telecommunications firm to compete against larger companies that offered a broader range of telecommunications services. The merger materialized less than a year later, in February 2005, when Verizon Communications Inc. announced its acquisition of MCI for about $6.7 billion in cash, stocks, and dividend payments. MCI ceased to exist as an independent company under the terms of the merger, which was completed in 2006.

As Edwards (2003) notes, these scandals raised fundamental questions about the motivations and incentives of executives and about the effectiveness of existing corporate governance practices, not only in the United States, but also in other parts of the world, including, What motivated executives to engage in fraud and earnings mismanagement? Why did boards either condone or fail to recognize Saylor URL: http://www.saylor.org/books Saylor.org 25 and stop managerial misconduct and allow managers to deceive shareholders and investors? Why did external gatekeepers, for example, auditors, credit rating agencies, and securities analysts, fail to uncover the financial fraud and earnings manipulation, and alert investors to potential discrepancies and problems? Why were shareholders themselves not more vigilant in protecting their interests, especially large institutional investors? What does this say about the motivations and incentives of money managers?[3]

Because of the significance of these questions and their influence on the welfare of the U.S. economy, the government, regulatory authorities, stock exchanges, investors, ordinary citizens, and the press all started to scrutinize the behavior of corporate boards much more carefully than they had before. The result was a wave of structural and procedural reforms aimed at making boards more responsive, more proactive, and more accountable, and at restoring public confidence in our business institutions. The major stock exchanges adopted new standards to strengthen corporate governance requirements for listed companies; then Congress passed the Sarbanes-Oxley Act of 2002, which imposes significant new disclosure and corporate governance requirements for public companies, and also provides for substantially increased liability under the federal securities laws for public companies and their executives and directors; and the SEC adopted a number of significant reforms. [1] Lindstrom (2008). [2] “MCI, Inc.,” Microsoft® Encarta® Online Encyclopedia (2008). [3] Edwards (2003). Saylor URL: http://www.saylor.org/books Saylor.org 26

The Financial Crisis of 2008

Just as investor confidence had (somewhat) been restored and the avalanche of regulatory reform that followed the 2001 meltdown digested, a new, possibly even more damaging crisis, potentially global in scale and scope, emerged. While it has not (yet) been labeled as a “corporate governance” crisis, the “financial crisis of 2008” once again raises important questions about the efficacy of our economic and financial systems, board oversight, and executive behavior. Specifically, as the economic news worsens—rising inflation and unemployment, falling house prices, record bank losses, a ballooning federal deficit culminating in a $10 trillion national debt, millions of Americans losing their homes, a growing number of failures of banks and other financial institutions—CEOs, investors, and creditors are walking away with billions of dollars, while American taxpayers are being asked to pick up the tab (Freddie Mac’s chairman earned $14.5 million in 2007; Fannie Mae’s CEO earned $14.2 million that same year). Not surprisingly, ordinary citizens who have seen the value of the 401K plans shrink by 40% or more are asking tough questions: How did we get into this mess? Why should we support Wall Street? Where was the government? What has happened to accountability? While the causes of the current crisis will be debated for some time—Did we rely too much on free markets or not enough? Did special interests shape public policy? Did greed rule once again? Where were the boards of Bear Stearns, Lehman Brothers, and AIG? Were regulators asleep at the wheel? Incompetent?—one thing is for sure. Another wave of regulatory reform—this time possibly global in reach—is around the corner. And once again we will be asking the questions that prompted the writing of this book: What will be the impact on investor confidence? On corporate behavior? On boards of directors? On society?

Sarbanes-Oxley Act Overview

The Sarbanes-Oxley Act of 2002 imposes significant new disclosure and corporate governance requirements for public companies and also provides for substantially increased liability under the federal securities laws for public companies and their executives and directors. After it was adopted, the NYSE, NASDAQ, and AMEX adopted more comprehensive reporting requirements for listed companies, and the Securities and Exchange Commission (SEC) issued a host of new regulations aimed at strengthening transparency and accountability through more timely and accurate disclosure of information about corporate performance.

The most important changes concern director independence, the composition and responsibilities of the audit, nominating and compensation committees, shareholder approval of equity compensation plans, codes of ethics or conduct, the certification of financial statements by executives, payments to directors and officers of the corporation, the creation of an independent accounting oversight board, and the disclosure of internal controls.

Director Independence

New stock exchange listing requirements stipulate that the majority of directors of public companies be “independent.” [1] The rules further state, “No director will qualify as independent unless the board affirmatively determines that the director has no material relationship with the listed company” and require companies to disclose determinations of independence in its annual proxy statement or, if the company does not file an annual proxy statement, in the company’s annual report on Form 10-K filed with the SEC. The rationale for increasing independence was that shareholders, by virtue of their inability to directly monitor management behavior, rely on the board of directors to perform critical monitoring activities and that the board’s monitoring potential is reduced, or perhaps eliminated, when management itself effectively controls the actions of the board. Additionally, outside directors may lack independence through various affiliations with the company and may be inclined to support management’s decisions in hopes of retaining their relationship with the firm. Requiring a board to have a majority of independent directors therefore increases the quality of board oversight and lessens the possibility of damaging conflicts of interest.

Audit Committees

Rule 10A-3 under the Exchange Act directs the stock exchanges and NASDAQ to require listed companies to have an audit committee composed entirely of independent directors. Subsequent stock exchange and SEC amendments further strengthened this provision by requiring the following, among other things:

  • Each member of the audit committee is financially literate, as such qualification is interpreted by the board in its business judgment, or will become financially literate within a reasonable period of time after his or her appointment to the audit committee.
  • At least one member of the audit committee is a “financial expert,” defined as someone who has
    • an understanding of financial statements and generally accepted accounting principles;
    • an ability to assess the general application of such principles in connection with the accounting for estimates, accruals, and reserves;
    • experience preparing, auditing, analyzing, or evaluating financial statements;
    • an understanding of internal controls and procedures for financial reporting;
    • an understanding of audit committee functions.
  • The audit committee has a charter that addresses the committee’s purpose and sets forth the duties and responsibilities of the committee.
  • The audit committee obtains and reviews an annual report by the independent auditor regarding the firm’s internal quality-control procedures, discusses the audited financial statements with the independent auditor and management, and reports regularly to the board of directors.
  • The audit committee is directly responsible for the appointment, compensation, retention, and oversight of the outside auditors. Additionally, the outside auditors must report directly to the audit committee.
  • The audit committee has the authority to engage independent counsel and other advisers, as it determines necessary to carry out its duties.
  • The audit committee approves, in advance, any audit or nonaudit services provided by the outside auditors.

The reasons behind these reforms are self-evident. Audit committees are in the best position within the company to identify and act in instances where top management may seek to misrepresent reported financial results. An audit committee composed entirely of outside independent directors can provide independent recommendations to the company’s board of directors. The responsibilities of the audit committee include review of the internal audit department, review of the annual audit plan, review of the annual reports and the results of the audit, selection and appointment of external auditors, and review of the internal accounting controls and safeguard of corporate assets.

Compensation Committees

New NYSE and SEC rules require that

  • listed companies have a compensation committee composed entirely of independent directors;
  • the compensation committee has a written charter that addresses, among other things, the committee’s purpose and sets forth the duties and responsibilities of the committee;
  • the compensation committee produces—on an annual basis—a compensation committee report on executive compensation, to be included in the company’s annual proxy statement or annual report on Form 10-K filed with the SEC.

These reforms respond to the unprecedented growth in compensation for top executives and a dramatic increase in the ratio between the compensation of executives and their employees over the last 2 decades. A reasonable and fair compensation system for executives and employees is fundamental to the creation of long-term corporate value. The responsibility of the compensation committee is to evaluate and recommend the compensation of the firm’s top executive officers, including the CEO. To fulfill this responsibility objectively, it is necessary that the compensation committee be composed entirely of outside independent directors.

Nominating Committees

New NYSE and SEC rules stipulate that

  • a listed company must have a nominating and corporate governance committee composed entirely of independent directors;
  • the nominating and corporate governance committee must have a charter that addresses the committee’s purpose and sets forth the goals and responsibilities of the committee.

Nominating new board members is one of the board’s most important functions. It is the responsibility of the nominating committee to nominate individuals to serve on the company’s board of directors. Placing this responsibility in the hands of an independent nominating committee increases the likelihood that chosen individuals will be more willing to act as advocates for the shareholders and other stakeholders and be less beholden to management.

Shareholder Approval for Equity-Compensation Plans

An equity-compensation plan is a plan or other arrangement that provides for the delivery of equity securities (including options) of the listed company to any service provider as compensation for services. Equity-compensation plans can help align shareholder and management interests, and equity-based awards are often very important components of employee compensation. New NYSE and SEC rules require shareholder approval for stock option plans or other equity compensation plans and any material modification of such plans. These rules are subject to a significant number of exemptions, however. Separately, new accounting rules have changed the accounting of stock options. [1]




[1] For more on this subject, see Chapter 8 “CEO Performance Evaluation and Executive Compensation” in this volume.



Codes of Ethics and Conduct

New rules also require that public companies must adopt and disclose a code of business conduct and ethics for directors, officers, and employees; include its code of business conduct and ethics on its Web site; and each annual report filed with the SEC must state that the code of business conduct and ethics is available on the Web site. The code of conduct must comply with the definition of a “code of ethics” set forth in section 406 of Sarbanes-Oxley and provide for an enforcement mechanism that ensures prompt and consistent enforcement of the code, protection for persons reporting questionable behavior, clear and objective standards for compliance, and a fair process by which to determine violations.

Certification of Financial Statements

Sarbanes-Oxley requires the following:

  • The principal executive officers and principal financial officers of public companies should provide a written statement with each periodic report that contains financial statements certifying (a) the report complies with the requirements of section 13(a) or 15(d) of the Exchange Act; and (b) the information contained in the report fairly presents, in all material respects, the financial condition and results of operations of the company
  • The above certifications need to be filed separately with the SEC as exhibits to the periodic reports to which they relate.
  • The principal executive officer and principal financial officer of the company must certify in each annual and quarterly report that
    • the certifying officers have reviewed the report;
    • to the certifying officers’ knowledge, the report does not contain any untrue statement of material fact or omit to state a material fact necessary in order to make the statements made, in light of the circumstances under which the statements were made, not misleading;
    • to the certifying officers’ knowledge, the financial statements and other financial information included in the report fairly present, in all material respects, the financial condition and results of operations of the company as of the dates of, and for the periods presented in, the reports;
    • the certifying officers (a) are responsible for establishing and maintaining effective internal controls, (b) have designed such internal controls to ensure that material information relating to the company is made known to them, (c) have evaluated the effectiveness of the controls as of a date within 90 days prior to the filing of the report, (d) have presented in the report their conclusions about the effectiveness of the controls, (e) have disclosed to their outside auditors and audit committee any significant deficiencies in the internal controls and any fraud involving management or other employees who have a significant role in the company’s internal controls, (f) have identified for the outside auditors any material weaknesses in the internal controls, and (g) have indicated in the report whether or not there were significant changes in the internal controls that could affect those controls, including any corrective actions.

Any CEO or CFO who provides the certification knowing that the report does not meet the above listed standards can be fined up to $1 million, imprisoned for up to 10 years, or both.

Payments to Directors and Officers

Sarbanes-Oxley and subsequent SEC directives stipulate that

  • no public company may make a personal loan to a director or officer, and existing loans may not be materially modified or renewed;
  • the CEO and CFO of a public company that restates its financial statements as a result of misconduct will have to forfeit any bonuses, incentives, equity-based compensation, and profits on sales of company stock realized during the 12-month period following the first public issuance of the financial document or report containing the inaccurate financial statements;
  • the SEC has the authority to freeze any extraordinary payments by the company to any of its directors or officers while an investigation is ongoing;
  • the SEC can bar a person who has violated section 17(a) of the Securities Act of 1933 or section 10(b) of the Exchange Act from serving as a public company director or officer;
  • directors, officers, and 10% of stockholders of public companies are required to report changes in beneficial ownership within 2 business days after the relevant transaction;
  • directors and executive officers are prohibited from buying or selling equity securities during a blackout period;
  • non-management directors are required to meet in regularly scheduled executive sessions without management present.

Creation of the PCAOB

The Public Company Accounting Oversight Board (PCAOB) is a private-sector, nonprofit corporation created by Sarbanes-Oxley to oversee accounting professionals who provide independent audit reports for publicly traded companies. Its responsibilities include

  • registering public accounting firms;
  • establishing auditing, quality control, ethics, independence, and other standards relating to public company audits;
  • conducting inspections, investigations, and disciplinary proceedings of registered accounting firms;
  • enforcing compliance with Sarbanes-Oxley.

When Congress created the PCAOB, it gave the SEC the authority to oversee the PCAOB’s operations, to appoint or remove members, to approve the PCAOB’s budget and rules, and to entertain appeals of PCAOB inspection reports and disciplinary actions.

Disclosure of Internal Controls

As directed by section 404 of Sarbanes-Oxley, the SEC adopted a rule requiring registered companies to include in their annual reports a report of management on the company’s internal control over financial reporting. Theinternal control report must include

  • a statement of management’s responsibility for establishing and maintaining adequate internal controls;
  • a management assessment of the effectiveness of the company’s internal controls including disclosure of any material weaknesses;
  • a statement identifying the framework used by management to evaluate the effectiveness of internal controls;
  • a statement that the independent auditors have issued an attestation report on management’s assessment of the company’s internal controls over financial reporting. In addition, companies must provide disclosure about off-balance-sheet transactions in registration statements, annual reports, and proxy statements.


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