Us Corporate Scandals And Sarbanes – Oxley Act 2002

Table of Content


There are two approaches to the corporate governance framework. The first is a market driven model which comprises self-regulation that operates independently of state intervention. This model operates on public pressure such as compulsion by institutions such as stock exchanges and institutional investors who prescribe certain norms and conditions of good governance where corporate entities have no choice except to follow them. The second model evolves from the intervention of the state and is characterized by legislative requirements, especially with respect to disclosures, by way of prescription rather than being based on suggestion or principles.

The latest legislative developments in countries like the UK, North America, and Australasia which have corporate governance frameworks based on compliance, are examples of the second model. Of these two, in the US a significant contribution has been market-driven shareholder activism as a reaction to the management abuses and corporate scandals which rocked the US economy to a great extent.

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Corporate Governance Legislation in the United States

Prior to the enactment of the Sarbanes – Oxley Act in 2002, corporate governance measures in the Unites States were in the developing stage and only self-regulated measures had evolved as major initiatives. The California Public Employees Retirement System and the ‘Guidelines on the Significant Corporate Governance Issues’ published by General Motors are some of the self regulatory corporate governance initiatives.

In contrast to the strategies being adopted by the UK and the European Union, the United States is in favour of enforceable legislation for regulating corporate governance measures. As a result, corporate governance standards in the US include the prescription of fines and imprisonment as sentences for non-compliance with the various standards advised. These sentences function as sanctions against erring companies and their directors.

The corporate scandals of Enron, Tyco and Worldcom resulted in the promulgation of the Sarbanes – Oxley Act in 2002 as the sole legislation concerning corporate governance issues. The legislation made significant changes to corporate governance reporting requirements. These changes are applicable to all companies required to file periodic reports to the Securities Exchange Commission (SEC).

The unique and interesting feature of the Sarbanes – Oxley Act can be seen from the fact that this Act has created a corporate governance code that is enforceable through the operation of legislation. The other important feature of this Act is its extraterritorial impact. The provisions of this Act are applicable to all companies listed on the New York stock exchange and the NASDAQ, irrespective of their country of origin and registration. These companies of non-United States origin have their shares listed on US stock exchanges through the issue of instruments known as American Depository Receipts (ADRs).

The Act has set out minimum standards which incorporate corporate governance principles that until that time had no compelling or binding force on the entities. Until enactment of the Act, these were merely guiding principles and not enforceable legislation:

The main requirements of the Act are:

  1.  The requirement that the majority of independent directors be on the board of directors;
  2.  Standards for determining director independence;
  3.  Independent audit, compensation, nomination and governance committees with specific responsibilities;
  4.  The responsibility of audit committees for annual independent auditing of the corporation, disclosure and to ensure compliance with legal and regulatory obligations;
  5.  The holding of regular meetings of non-management directors;
  6.  Regular board committee self-evaluations; and
  7.  The development and publication by companies of specific governance guidelines and codes of conduct for their operations.

US Perspective on Corporate Governance Measures

The major failure of corporate governance measures has been identified as one of the main causes of the large scale corporate scandals in the United States. The provisions included in the Sarbanes – Oxley Act applicable to corporations that are subject to the Securities Exchange Act 1934 have been suitably amended to ensure higher standards of corporate governance among the various corporations.

The significant provisions have been designed to address enhanced and effective internal control measures and higher transparency levels in the disclosure of financial and other information which are at the root of good corporate governance. ‘Sarbanes–Oxley and state corporate statutes provide the framework for management, board and audit committee responsibilities.’

Able assistance to the Sarbanes – Oxley Act to achieve its object of ensuring good corporate governance measures is being provided by other Federal and State Laws including ‘anti-trust laws, securities laws and environmental laws’. Apart from imposing specific compliance requirements this legislation also provides ‘guidance and direction’ to corporations in the matter of maintaining good governance principles.

The listing requirements and policies of the New York Stock Exchange and the National Association of Securities Dealers Quotation System (‘NASDAQ’), as well as the Generally Accepted Accounting Principles of the accounting profession, also play a role along with the decisions of federal and state courts and the policies of governmental agencies.

One of the agencies able to exert effective pressure on corporations in respect of their corporate governance measures is the Securities Exchange Commission (SEC). The functions of the SEC include the ultimate protection of investors’ interests by overseeing various issues concerning dealings in securities for raising capital and also ensuring compliance with the listing requirements for effective regulation of the stock markets in the US. Because of the stringent penal sanctions provided, both formal and informal pronouncements by the SEC are being followed effectively by the corporations whose shares are listed in the stock exchanges and are publicly traded.

Development of Corporate Governance in the United States

It is important to review significant developments in corporate governance activities to gain an insight into the efforts of the United States to promote governance measures, especially after the incidence of major corporate scandals like Enron and WorldCom. The developments attained by the country with respect to federal and state laws, and in particular the securities laws, have been greatly influenced by the culture of the country. It is also of importance to examine these cultural values which have contributed to the development of various enactments in the country.

The corporate governance-related statutes, rules, regulations and court decisions often contain provisions or guidelines placing restraints on corporate action, but the relationship between shareholders and the board of directors is characterized by the latitude allowed to the board through application of the business judgment rule.

Immediately following the Civil War, the worst event in the economic history of the United States, several monopolistic and discriminatory trade practices started to corrupt the functioning of business enterprises, through the formation of business trust pools and other types of arrangements which were collusive in nature. These corrupt business entities resorted to price-fixing and other unethical business practices which led to the promulgation of the Sherman Act in 1890 to proscribe the undesirable monopolistic and restrictive trade practices in the country. Though there was no emphasis on strictly enforcing the provisions of the Sherman Act, the Clayton Act (1914) and the Robinson – Patman Act (1936) followed to strengthen the provisions of the Sherman Act.

The 1920s witnessed a spate of speculative and fraudulent activities in the securities market which necessitated the passing of ‘The securities Act’ in 1933 and the ‘The Securities Exchange Act’ in 1934. Corporate dealings in securities were greatly regulated by a number of amendments made to this legislation as well by the ‘rules, regulations, investigations and enforcement actions’ initiated by the Securities Exchange commission in later years.

During the period prior to 1960 – 1970 the corporate history of the United States witnessed an evasive attitude by boards of directors in respect of  their responsibility to ensure good corporate governance, but during the 1970s the attitudes and behaviour of the boards changed qickly due to  increased ‘legislative actions, court decisions and investigations by the SEC’. The cases of Escott v Barchris Construction Corporation, Penn Cent Transport Co and the Watergate scandal evidencing illegal corporate payments were important events that forced the US administration to enact the Foreign Corrupt Practices Act (FCPA) in 1977.

The FCPA amended the Securities Exchange Act of 1934 to require that public companies keep books in reasonable detail to reflect transactions and dispositions of assets and to maintain internal controls to require that there be accountability for the assets and transactions. The FCPA is an example of corporate governance by legislative fiat, although brought on by an unconscionable corporate behaviour.

Corporate governance measures took on a new dimension with the formation of a task force in 1979 and in 1980 this task force prepared a ‘Staff Report on Corporate Accountability’ incorporating changes in the securities laws as advised by the SEC. Further developments in the corporate governance spectrum were added by various court judgments after the Taskforce report. Emphasis was placed on the formation and enhancement of the responsibilities of audit committees by the ‘Blue Ribbon Report’ jointly sponsored by the New York Stock Exchange and NASDAQ on the recommendation of the SEC.  The report aimed at improving the performance of audit committees by providing recommendations and guidelines for best practices which were later adopted by the SEC, New York Stock Exchange and NASDAQ.

Over the period, the roles and responsibilities of the board of directors have been subject to many judicial decisions and reviews. Most of the decisions and debates centering round the audit committees are of recent origin, especially after the Enron corporate scandal. In fact, the Sarbanes – Oxley Act requires the entire board to be the audit committee, although this requirement suffers from a shortcoming, in that, where the Chief Executive Officer of the company is also a member of the board, he cannot function as a member of the audit committee as he is not independent. Thus corporate governance in the United States has developed over many years through laws, court decisions, regulations, policies, best practices and the other influences. As we have seen, repercussions from questionable corporate behavior, periods of economic distress and corporate failures have been the principal catalysts for change in these influences.

US Corporate Scandals

‘The Enron Corporation collapsed in an accounting scandal involving large-scale financial statement misrepresentations and undisclosed self-interested transactions by the senior financial officer.’(Romano, 2005) Just one year before the debacle, Enron was in the seventh position in the US in terms of market capitalization.

The firm had a very high reputation in the energy trading and distribution having high regards as one of the top-performers with foresighted innovative qualities. Enron’s failure happened at a time when the US economy was in an economic shock caused by 9/11 terrorist event and Enron attracted much media attention. “Moreover, in the months following Enron’s demise, accounting and executive self dealing scandals embroiled additional public companies.

When similar problems led WorldCom, Inc to file the largest-ever bankruptcy reorganization proceeding in US history Moreover, in the months following Enron’s demise, accounting and executive self dealing scandals embroiled additional public companies. When similar problems led WorldCom, Inc. to file the largest-ever bankruptcy reorganization proceeding in US history, after months of a stalled legislative process Congress acted quickly, adopting the extensive regulatory regime for accountants and public issuers imposed by SOX”

Events Leading to the Bankruptcy of Enron

When the company was at its peak, it was reporting a turnover of $80 billion and profits of about $1billion. The company was recognized as the most innovative company for six consecutive years by Fortune. After a series of changes in the top executive positions, amidst rumors about the financial trouble in the company, Enron announced charges against the profits and a reduction in shareholder’s equity due to related transactions with LJM-2, partially owned by Enron’s CFO. The role of ‘LJM partnerships is to provide Enron with a partner for asset sales and purchases as well as an instrument to hedge risk’ (Munzig, 2003)

Less than a month from this time Enron announced about the accounting errors relating to transactions with another partnership of the CFO. Also there were restructuring of some accounting transactions as short term solutions to basically cover the transactions which were flawed and baseless. These transactions enabled the company executives to earn millions of dollars by a careful maneuvering of the accounting records and keeping the share prices of the company at artificially higher prices.  Such statements lead to formal investigation by Securities Exchange Commission in to Enron partnerships. As a result of such investigations serious dubious accounting transactions were brought to light which finally led to the filing of one of the largest bankruptcies of the country.

The transactions of Enron gave new insight into the corporate governance lapses in the case of the management of Enron. As Peter Munzig points out:

  • First one being the dual role Kopper played as manager and investor of the partnership while an employee of Enron. (Mr. Kopper was the managing director of Enron’s global finance unit and reported directly to the CFO) This is a blatant conflict of interest, explicitly violating Enron’s own Code of Ethics and Business Affairs.
  • The second governance issue is in connection with the Compensation Committee’s lack of review of Kopper’s compensation resulting from the transactions.
  • The third governance issue deals with the lack of auditing oversight from the Audit and Compliance Committee concerning the decision not to consolidate the entity.

These kinds of corporate practices result in a financial loss not only to the company concerned, but also affect innumerable investors who have invested their hard earned money in the stocks and securities of the limited companies. Since the investments in securities are made with pure trust in the board of directors and other executives of the companies, they have an onus to protect the interest of the shareholders of the company whether they are major or minor; individuals or institutions.

In the case of Enron, investors’ confidence was taken for a ride by the top management of the company that has witnessed the demise of a giant business enterprise. Along with the company, thousands of investors who had invested millions of dollars lost their savings and were left high and dry. It was a similar situation for other stakeholders of the company such as the innocent employees of the company and the creditors who supplied products and services to Enron on the faith of the ill-earned reputation in the market by sheer book adjustments and dubious entries.

Moreover, the executives of the company amassed a large volume of money which otherwise would not have been earned by them. This money and wealth was earned by them by playing confidence tricks. The pity and irony of the situation is that the statutory auditors who were supposed to be the watch dogs to protect the interests of all the internal and external stakeholders never brought these frauds and misdeeds to the public to caution them against the peril of losing their investment.

Nikos Passas  (2005) strongly contends that harmful corporate practices are criminal in nature be they financial or otherwise; lawful or illegal and such practices result in the degrading of the environments in the third world and other tangible consequences detrimental to the public interest. They may result in the loss of numerous lives and wanton destruction of large number of properties belonging to both public and private sector. The author opines that they can also be claimed as ‘legal crimes’.

Corporate Scandals – Difference in the US and European Contexts

One of the major and serious issues that results from poor corporate governance is corporate scandal in the form of accounting and financial frauds. While analyzing the incidence of corporate scandals globally, two issues emerge that need to be addressed to find out the reasons for such happenings; first, the nature of the corporate scandals differs from economy to economy and secondly, the reason for occurrence of corporate scandals in one economy and not in another even though both economies are subject to the same economic conditions.

A possible explanation for this phenomenon may lie in the structure of the ownership of the corporate entities in the respective economies. It is also possible to explain based on past experience that a spate of corporate scandals follows a stock market bubble and serious regulative measures in the form of new regulations would also follow as a natural consequence.  This experience can be related to the corporate scandals that happened in Europe and the United States during the start of the millennium immediately after the burst of the stock-market bubbles during the early 2000s.

While such incidents resulted in the provision of regulatory measures like the Sarbanes – Oxley Act in the United States due to large scale accounting and financial irregularities, in Europe the aftermath was not so severely felt.  This can be seen from the fact that the restatements of financial statements in Europe were rarely found whereas at least 10 percent of the listed companies in the US resorted to such restatements in the period from 1997 to 2002.

‘While Europe also had financial scandals over this same period (with the Parmalat scandal being the most notorious), most were characteristically different from the US style of earnings manipulation scandal (of which Enron and WorldCom were the iconic examples).’ It can be argued that the differences in the structure of the shareholding of the corporate entities may be considered as one of the reasons for various kinds of corporate scandals having differences in their nature and the identity of the people responsible for such frauds, and also for the varying number of such incidents.

It may be noted that the whole corporate world can be grouped under two broad corporate governance systems; a dispersed ownership system represented by a strong security market with high transparency and controlled by a disciplinary mechanism which provides for stringent disclosure standards, and a concentrated ownership system having a weaker securities market and lesser transparency and disclosure measures.

In the dispersed ownership systems corporate executives tend to be the perpetrators of frauds while in the concentrated ownership systems the controlling shareholders take the lead in indulging in accounting and other frauds. The operating methods of the two groups are also different in that corporate management adopts earnings management as the manipulating device; the controlling shareholders take the route of exploiting the private benefits of control.

It also happened that the auditors, analysts and credit rating agencies (generally termed as ‘gatekeepers’) failed both in the Europe and the US but in different ways. As a result of the debacles many reforms have been suggested in the form of new regulations. But it must be appreciated that a remedy in the form of Sarbanes – Oxley Act as in the United States may not be suitable in Europe.

Sarbanes-Oxley Act

The Sarbanes – Oxley Act (shortly known as the SOX Act) named after two US senators, has brought the most significant financial legislation in the history of US financial markets 70 odd years after the enactment of the Securities Act of 1933 and the Securities Exchange Act of 1934. The Act was an initiative to restore shareholder confidence in the total system trading in public securities after the US economy was flooded by a series of corporate scandals that led to the loss of billions of dollars of the investing public’s money.

Purposes of the Sarbanes-Oxley Act

The purposes for which the legislation was enacted are to:

  •          Restores public trust in the public securities market
  •          Improve corporate governance and promote ethical business practices
  •          Enhance transparency of financial statements and disclosures
  •         Ensure that company executives are aware of material information emanating from a well-controlled environment
  •         Hold management accountable for material information that is filed with SEC and released to investors (Cheung, 2006).

Another important impact of the passing of this Act had been found out by Karan and Sharifi (2006)[18] in that the Act will have a profound effect on the probable merger and acquisition deals, as after passing of the Act, both the acquirer and the target should understand the implications of the cost and effect of the Act and any firm that has even a slightly shady accounting background will be neglected by the acquirers. This may act as a deterrent for the number of such merger and acquisition deals that are likely to be taken up.

Salient Features of the Act

 ‘The act, popularly known as the Sarbanes-Oxley Act (SOX), is designed to protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws.’ Without a doubt, the Sarbanes-Oxley Act is the single most important piece of legislation affecting corporate governance, financial disclosure and the practice of public accounting since the US securities laws of the early 1930s. And, it is clear that public companies and the accounting profession have made tremendous progress in meeting the rigorous requirements of this legislation.

The groundwork necessary for the positive reaction of the global capital markets encouraging heavy inflow of international investments is created by the introduction of this Act which has made certain provisions mandatory for the companies for having them listed in the US. This has also altered the structure of the legislative regime of the country. The modus operandi of the Act is improve upon the accuracy of the reporting requirements in respect of disclosures by the companies and by requiring increased transparency in the transactions to oversee the activities of the auditors with regard to discharge of their functions. In this way the Act proposes to protect the investors to a great extent.

The salient feature of the Act is the provisions it has created as to the restriction on the capacity of the corporations that are contemplating to raise capital in the US capital markets. Thus it has become necessary for all the companies irrespective of their domicile to follow the restrictions imposed by the Act if they want to secure access to the primary exchanges. In addition, it is also necessary fort them to follow the listing requirements of the primary exchanges that are governed now by a more powerful and authoritative Securities Exchange Commission.

The important provisions of the SOX Act insist the certification by the CEO and CFO about the veracity and integrity of the financial statements. They have to certify that financial statements of the companies are true in all respects without any omissions and also they do not contain any misleading statements.

Moreover such certification should vouch that the financial information reports fairly describe the financial status of the company. By certifying so, the executives commit themselves to the readers and general public that they are responsible for such statements and in taking up such responsibility they have evaluated the effectiveness of the internal control measures being adopted by the company over its financial affairs. They also commit that they have disclosed to the company’s auditors and the audit committee material weaknesses if any in the internal controls or about any fraud that they have come across.

Any willful wrong declaration would be subject to a penalty up to $ 1 million and imprisonment up to 10 years. They are entitled to rely on mini certifications from the subsidiary companies issued by the respective CEOs and CFOs. Thus the Act has made the top executives of the company squarely responsible for the correct reporting of the financial state of affairs of their companies.

After-effects of the Act

Robert F. Radin and William B. Stevenson (2006) observe that ‘three years after the passage of Sarbanes-Oxley, we have seen a substantial increase in the time public company directors spend on their board duties and the time that executives devote to reporting matters.’ It can be construed that this increased focus on the discharge of their responsibilities with more care and involvement was the direct result of the ascertainment of the serious after-effects of any misrepresentations in the financial and other statements. Such awareness of the dire consequences have caused CEOs and CFOs to realize the need for accuracy in the presentation of financial statements and also the importance of transparency in their dealings and their disclosures.

According to the Protivity Inc Report (2003)  Insights on To-day’s Sarbanes-Oxley and Corporate Governance Challenge CFOs are focused on making their organizations aware of the Sarbanes-Oxley Act requirements through appropriate education, presentations and communications and are working to align various organizational processes with these requirements. Moreover, public companies are taking steps to ensure their directors are aligning their practices with the guidelines set forth by the Act and listing requirements.

Hemphill (2005),on the basis of the study from Coopers that measures the opinion of directors and CEOs of the top 2000 publicly traded companies, reports that ‘Reflecting the increasing board demands on a director’s time, “professional directors” who sit on six or more boards are fading away. In 2003, only 33% of CEOs and 16% of outside directors were limited to additional board seats, compared with 43% and 29%, respectively, in the 2004 survey’.

Richard W. Leblanc (2004) has observed that the experience of the directors is critical to the effectiveness with which the board can function, ‘however, evidence that board independence has neutral to negative effects on board effectiveness is not’. Stephen Wagner and Lee Dittmar in ‘The Unexpected Benefits of Sarbanes-Oxley Best Practice’ observe

Perhaps SOX’s most burdensome element was Section 404, which says that it is management’s responsibility to maintain a sound internal-control structure for financial reporting and to assess its own effectiveness, and that it is the auditors’ responsibility to attest to the soundness of management’s assessment and report on the state of the overall financial control system.

On these views, Peter Van der Heyden responds by saying that although as a result of SOX there resulted a highly efficient accounting procedure, ‘less duplication of data entry and checking, clearer definitions of the content of reports, more standardization of functions across different divisions or geographic locations, and so on’, the function of accounting is not just to show the numbers but to help senior management in taking meaningful decisions.

One of the studies undertaken by Rajeeva Sinha (2006)[29] on corporate governance shows that there is interdependence between external and internal governance mechanisms in the monitoring of top management and there are differential effects of the external governance mechanisms (in our case regulatory and the MCC) on the effectiveness of the internal corporate governance mechanisms. Thus it can be said that corporate governance measures should be capable of effecting improvements in the environment both internal and external to the firms.

Effects of Passing of the Sarbanes – Oxley Act on Executive Compensation

Stock Options were at one time the favorite and popular method of compensating senior and middle level corporate executives for achieving desired stock-price gains in the short-term. However, the happenings in Enron had made many of the companies and their senior leaders to rethink executive compensation in the form of stock options, as such options were the gateway for corporate fraud.

While there had been a tremendous increase in compensation, 313 percent from 1990 to 2003, corporate profits increased only 128 percent with an explanation increment of 41 percent. In spite of the increase in the quantum of the compensation payable, the companies and their boards of directors are looking at different methods of executive compensation so that they can attract and retain the best available talent.

Introduction of the Sarbanes – Oxley Act has made most of the major listed companies discard stock options as a form of executive compensation except for the top level leaders. But such a shift in compensation methods has not been favoured by many of the top-tier executives as they consider stock options give them a sense of ownership, while the other options were viewed only as entitlements. ‘This fundamental tenet of ownership is leveraged to bolster and to motivate individuals to improve corporate performance.

Unfortunately, the extremes of this same drive can sometimes result in executives ignoring corporate warning signs or putting their own interests above the greater good of the company.’ Due to the adverse effects such forms of compensation generate, the Sarbanes – Oxley and the Stock Exchange regulations have placed some restrictions on executive compensation offered by corporate entities. Some of these restrictions are:

  •  A total prohibition on the provision of personal loans or other forms of credit to the members of the board of directors and other officers of the company.
  •  Any incentive-based compensation must be dispensed with if received by a C-level employee on the basis of a financial report resulting from the misconduct of such employee.
  •  The company should ensure that adequate internal controls are in place and a certificate to this effect is issued by the company.
  •  There should be a valuation of the executive compensation schemes by accountants who are independent of the companies concerned.
  •  The companies should be completely transparent in reporting of expenses relating to employee compensation options.

Alternative Forms of Executive Compensation

Companies have devised various new methods of executive compensation. One  such method is a traditional ‘deferred stock options’ where the executive contributes a certain percentage of their monthly earnings for a preset period of time and at the end of the period the executive is entitled to purchase the option or in some cases one and a half options of the stocks of the company.

Another option that is increasingly being considered for compensating corporate executives is to make them participate in long-term bonus plans where contributions are made into a pool which vests over time.  Based on the defined tenure of the pool substantial cash payouts are considered for the different executives. The only shortcoming of this executive compensation method is that investments in shares may result in more lucrative returns to the executives than the pool money invested in any other form.

Public Company Accounting Oversight Board

The Sarbanes-Oxley Act created the Public Company Oversight Board (PCAOB) which was entrusted with the responsibility of regulating the auditing of public companies in the USA. The Board has made it mandatory for auditors to register with the Board. The Board will create procedures for quality assurance and independent ethical standards with which the auditors are required strictly to adhere.

The Act also contains rules that govern the provision of audit and non-audit services by the auditors to the companies on behalf of which the company is acting in the capacity of auditors. Further to this, the Act has also provided disclosure requirements in respect of the fees and charges received by auditors for audit and other services. Thus it may be stated that the independence of auditors, being the scrutinizers, is being subjected to wide scrutiny, in the aftermath of the corporate scandals in the US.

Corporate Governance and the Structure of the Board of Directors

Fama and Jensen (1983) observe that the board of directors of any company can be regarded as the ‘heart of the corporate governance’ as they have been delegated and are expected to exercise controlling authority on the top management in their decision-making functions. The board of directors has also been vested with the power of monitoring the integrity of the financial statements of the companies concerned. There are usually different ways of structuring the board of directors depending on the requirements of the organization. There are two schools of thought about the purpose for which, and the nature of, the structure of the board of directors.

According to one view, the boards are formed to increase managerial control over companies and hence the boards should be structured to have more participation from management than outsiders as independent directors.  In this case, the boards will have more insight into the operations of the firm. The other viewpoint is that the boards are formed basically to reduce agency costs and this school believes that the boards should be structured to have more outside independent directors so that management may have to get more ratification from the boards for their actions and decisions.

In this way the difference between the interests of  management and the shareholders is bound to be narrowed. ‘The conflict between the two viewpoints lies in the level of control over management exercised by shareholders. Some firms are structured to emphasize the board of director’s ability to monitor and control management while other firms are not.’ These are opposing views in the sphere of corporate governance and many companies have structured their boards of directors in such a way that they exercise managerial control as well as monitoring over the activities on the management.

Corporate Governance and the Duties of Directors in the US Context

The fiduciary duties of directors in the sphere of corporate governance can be identified from the perspective of two focal points; one as imposed by the requirements of the corporate governance framework with respect to the discharge of their functions and the other as an ongoing duty towards the shareholders and the company.

The interrelationship of this function as expected by corporate governance implementation and the general duties of directors is not very complex in nature, in the sense that the duties expected of directors in the form of members in various committees towards the corporate governance framework is quite distinct from the regular duties of directors in the day to day functioning of the firm. Thus corporate governance places special responsibilities on the directors who function as members of the audit committee to act as the connecting link between the company and the integrity of the external auditors in the discharge of their gate-keeping function.

In the discharge of such functions as members of the audit committee, directors should act above board in the public interest beyond their duties towards the company’s present shareholders. Prioritizing the discharge of these two responsibilities effectively in the company’s as well as the public interest is the role of the director.

The second factor that needs active consideration in the matter of the duties of the directors under corporate governance is the duty of loyalty to the corporation. ‘That is, a director’s duty of fidelity to the interests of the corporation imposes more than an obligation to refrain from participating in board decisions in which the director has an undisclosed and material financial or other economic interest.’

The general objective of the corporate governance reforms is to ‘enrich the content of the loyalty’ of directors toward fulfilling their duties towards the company as well as the public. In fact, legitimizing the extent to which the directors of US corporations are moved away from the influence of the shareholders depends largely on enriching the content of this duty of loyalty of the directors.

Of late there has been an increased skepticism as to whether most of the directors of US corporations have the capacity and the will power to discharge their duties in a manner that enables them to form their own judgments in decisions independent of other managerial influence. The answer to this question is viewed pessimistically as the corporate governance measures recommend increasing the participation of more independent outside directors in comparison to those who belong in the corporate echelons. However this position needs to be proved over time – that independent directors will be able to make independent judgments. In this context it is also to be seen to what degree the directors are independent of shareholders in the majority of the US public corporations.

The striking feature of the Delaware corporation statute,[33] in making the removal of directors by the majority of shareholders impossible without cause where the directors’ terms are staggered, implies the difficulty in establishing the governance standards in respect of the duties of directors in respect of US corporations. However in the UK context the situation is different, with section 303 of the UK Companies Act 1985 providing a simple majority of shareholders the right to remove any or all of the directors.

The power under section 303 is enhanced by the introduction of section 368 whereby 10 percent of the shareholders may call for a shareholders’ meeting to consider, among other things, changes in the Board. Thus the position of the board of directors in the UK context is more vulnerable than that of their US counterparts as there are more opportunities for intervention by the shareholders.

Corporate Governance and Audit Committees in the US Context

The content of directors’ duties and the effective internal control mechanism for a successful implementation of the corporate governance principles and framework is assisted by the ‘Audit Committees’ through which the directors discharge their functions. Moreover, governance reforms assign to audit committees an essential linkage function with external auditors, thereby internalizing into the corporation’s internal governance a mechanism that furthers systemic interests in the integrity of gatekeeping functions served by the external auditors.”

In fact this linking function justifies the independent quality requirement of the directors as distinct from the qualities required for the discharge of their regular duties to the present shareholders. The Sarbanes – Oxley Act (SOX) has specific requirements for the formation of audit committees by the firms subject to the Act. ‘Section 301(2) provides that an audit committee shall have direct responsibility for the appointment, compensation, and retention of any accounting firm employed “for the purpose of preparing or issuing an audit report or related work”. The accounting firm appointed by the company shall have the reporting responsibility to the audit committee.

The function of the audit committee includes overseeing the audit function of the accounting firm and also resolving the issues that result in a disagreement between the management of the company and the accounting firm with regard to the reporting of the financial and non-financial issues. Exhaustive provisions have been made in SOX to provide the necessary authority to the audit committee to take the required steps so that the duties expected of it can be discharged effectively.

In effect the discharge of the functions of the audit committee will have its impact on the orientation of the directors who become members of the audit committee. While their position remains the same as directors of the company in so far as the discharge of their fiduciary duties are concerned, the inclusion of the directors in the audit committee places them in an anchor position to monitor the relationship between the management of the company and the external accounting firm appointed to conduct the audit of the company. In that situation the commitment of the directors is to make their position systemic and public-oriented.

Role of Accounting in Corporate Governance

The roles played by corporate accountants are varied and are of vital importance. The most prominent of these roles is the role of  the accountant in preparing and attesting the corporate financial statements which serves the purpose of presenting the factual financial position of the company to the investors and general public. The following are the principal statements that a company prepares and on which the investing public rely for making their investment decisions:

  •  Balance Sheet – showing the value of assets and liabilities of the company as on any particular date as well as the net worth of the company as at the end of any fiscal period.
  •  Statement of Income – exhibiting the amount of revenues received by the company for the fiscal year
  •  Statement of cash flows – the amount of cash flowing from and to the business entity on account of the operations carried out by the firm, its various investments and other financial transactions

These financial statements, with respect to all but the smallest and most closely owned enterprises, invariably include detailed notes, including explanations, details and other material information relevant to the statement items, and are accompanied by an Audit Report by independent accountants that attests to their fair presentation of the financial position and results of operation.

The roles of accountants in the light of the abovementioned statements with respect to the corporate governance framework may be considered as extending to two different functions. The first one is internal and can assume the description of a ‘stewardship function’ which has the purpose of evaluating the functioning and the performance of the management internally. Such evaluation is done on behalf of the management themselves and also on behalf of outsiders dealing with the company. The following corporate governance functions would fall under this category:

  •  Measurement of executive performance and compensation
  •  Effective evaluation of the performance of the products of the company
  •  Measurement of the performance of the various operating divisions of the company ( such measurement to include the income, expenditure and the resultant profitability)
  •  Deciding on the business policies which have a bearing on the financial status of the company (these financial issues may relate to the borrowings by the company, pricing policies and the investment decisions)
  •  Assisting the company in fixing the dividend policies of the company
  •  Enabling the company to take decisions on acquisitions and disposition of undertakings.

Although the list is not exhaustive all of the internal evaluation decisions are based on some kind of accounting information and any lack in the accounting system will lead to lack of accounting information which in turn will lead to an internal failure in corporate governance. Good corporate accounting is always at the root of good corporate governance.

The external role of accounting is often referred to as the ‘investor and creditor function’ and is concerned with providing detailed and relevant information to the external stakeholders such as creditors. Such information is also required by the investors who wish to buy the shares of any particular company. The investors and creditors base their decisions on information provided by the accountants for the kind of financial exposure they would like to take in investing or lending to the company. The American accounting profession often emphasizes this corporate accounting role.

The function of financial reporting is thus to ensure that sufficient information is being provided to prospective investors and creditors and other people who are have a need to assess the position of the company with respect to its capabilities of honouring its financial commitments in the matter of payment of dividends, payment of interest, payment of the ‘proceeds from the sale, redemption or maturity of securities or loans’ etc. ‘Thus, financial reporting should provide information to help investors, creditors and others assess the amounts, timing, and uncertainty of prospective net cash inflows to the related enterprise.’[36]

From the corporate governance point of view it is necessary to understand the functions of these financial statements in their proper perspective. The Balance sheet presents historical information on the value of assets and liabilities of the firm and also the ownership interests of the enterprise. Though most of the items are presented at their original cost some items need to be exhibited at their market or current value. The income statement presents for the year then ended the economic performance of the company in accordance with the established accounting principles. The cash flow statement presents for the year then ended the receipts and payments of the company.

It is also necessary to make a clear demarcation between the stewardship function and the investor and creditor function of the accounting.  While some of the aspects of the internal stewardship function look by their nature into the historical information, the investor and creditor function necessarily looks into the future. While the people within the firm who are entrusted with the job of decision-making can rely on the historical accounting information as the basis of their decisions, they must ensure that such information is reliable and relevant.

On the other  hand, those who have to take a decision with respect to future investments, including creditors or investors, can make use of the historical information as the starting point for arriving at the expected future status by a simple extrapolation of such historical figures. It is also quite possible that different people access and use the accounting data for different purposes and also some of them may generate additional information like ‘ratios, projections, valuations and estimates’ out of the presented data.

Those who base decisions upon accounting should be expected, particularly in the light of Enron and other celebrated recent accounting failures, to demand assurances (in rules, systems and enforcement structures) that accounting information is reliable. However, recent accounting failures have not been limited to issues of reliability. There have as well been questions with respect to the relevance, comparability, and sufficiency of accounting information.

Therefore it is reasonable to assume that the lessons provided by corporate scandals like Enron should increase awareness among those dealing with the financial statements to rely on the accounting statements only when they have thoroughly gone through such statements personally and are satisfied with the ‘amounts, contents, currency and other relevancy of information’ contained therein.

The reliability of the financial statements is usually assured by the auditors of the firm. The audits are carried out by independent accountants and the audits are carried out in accordance with established auditing standards. The assurances being provided by the audit include assurances that the statements have been prepared in accordance with generally accepted accounting principles; are free from material misrepresentation and present a true and fair view of the financial position of the company and of the results of the operations of the company upon which the report is made. Usually such assurances are included by way of statements in the audit report.

Audit failure with respect to material items—for example, failure to apply appropriate accounting principles, or material misrepresentations—renders the financial statements misleading because governing accounting principles have not been applied. There were, in fact, audit failures in most, if not all, of the recent accounting debacles: applicable accounting principles were not applied or misapplied, misstatements were reported on the financial statements, and the statements did not fairly present the financial position and/or results of operations of the enterprises involved.

Corporate Governance and Transparency

In almost all countries corporations, because of the nature of the form of organization and the attached limited liability, are duty-bound to make all information pertaining to their working available to the general public. ‘As economies and markets become increasingly complex, the amount and type of information required to be disclosed has increased in complexity too. In contemporary times, the disclosure of more specific financial information became an important instrument in world markets.’The compilation and presentation of financial data is of paramount importance for prospective investors who want to buy shares in different companies as well as to the creditors and even banking and other financial institutions.

In addition, transparent corporate information reporting often prevents fraudulent activities. Large corporations by virtue of their economic position acquired greater social power and as a consequence ‘accountability’ of the companies to the public has followed suit. This corporate power attains legitimacy only by addressing the accountability issue with great care and sincerity. Macmillan compares accountability of corporations with democratic elections, observing that ‘accountability in this context is to act as a device for legitimizing corporate power (in much the same way as democratic elections and the principles of administrative law make government accountable for its power and therefore legitimize that power.’

Considering the economic and social power multinational and transnational corporations can exercise across different economies and societies, it is vitally important to ensure that proper and stringent international disclosure requirements evolve so that such great private powers are legitimized.

Other corporate Governance Concerns

Mark Gillen,[41] while discussing the other corporate governance issues in the context of business income trusts, has identified the following issues that may determine the level of the corporate governance measures that may be needed to enhance the confidence of investors in business income trusts:

  • External management contracts that may lead to diversion of funds from the parent organisation
  • Methods of executive compensation – here also the concern is about the excessive outflow of funds from the business.
  • Difficulties the income trust structure might encounter in an economic downturn.
  • The methods of calculating and arriving at the distributable cash.
  • The ways in which the obtaining and disclosure of stability ratings are made.

Legal Origin of Corporate Governance

The development of strong capital markets in an economy largely depends on the legal system prevailing in that economy. It has been substantiated by studies conducted showing that the interests of the shareholders are more protected by common law institutions while civil laws do not have a role in such protection.  This differing ability of the legal institutions is responsible for making the capital markets of certain economies stronger, while in some other economies the markets remain weak. It has been proved that ‘transplanting the correct legal code (i.e., the common law) will enhance economic development.’

Economic development is achieved through progress of the financial markets and the relationship between the legal system and the development of financial markets depends on the ways in which the legal system protects the small investors. If there is an inherent fear in the minds of small investors that their investment will not result in any returns for them by the action of insiders, then they may not invest in those firms. If the shares are not bought by outsiders then there cannot be any development of the stock market in the country and this will affect the investments of the big owners in such cases, while the interests of the minority shareholders are protected by the common law systems.

The protection of minority interests is ensured by the fiduciary duties cast by the judge-made systems under common law. In common law the fiduciary duties range from controlling insiders to protecting the outside shareholders. The shareholders feel comfortable in buying the shares when they are confident that there is some system prevailing to protect their interests.

It is often the case that the protection systems offered by common law through fiduciary duties are facilitated by the various regulating bodies like the Stock Exchanges and the Securities Exchange Control as well as the by the legislature. However it is vitally important to note that ensuring the discharge of the fiduciary duties alone is sufficient to protect the shareholders’ interests. ‘Fiduciary duties do not protect distant stockholders from managerial mistake or from managers’ neglect of shareholders’ interests’.

Since the business judgment rule affects the potential of impending law suits, shareholders are bound to look to other avenues or the action of other institutions for the protection of their interests against the mistakes that might be committed by management. Thus, in those cases where the managers are found to be less oriented towards the protection of the shareholders, then the chances for the dominant shareholders to sell their holdings to other distant shareholders will not be bright due to the fall in the shareholder value. This has necessitated the corporate law, especially in the United States, to depend on other regulatory agencies like the Securities Exchange Commission (SEC) apart from the common law means for the protection of shareholder interests. Their protection is also achieved through the adoption of multiple means achievable under both legal systems.

Necessity for International Standards of Corporate Governance

The growth in the size of corporations and their increased interactions with various economies around the world increases the impact of their management failures on such economies. As the world markets become more and more complex with increased pressures in terms of competitiveness and fulfillment of social responsibility obligations, it becomes important to address the issues relating to corporate control and regulations rigorously. According to traditional theories control of the affairs of the corporation is handled by the owners themselves or by appointing their representatives on the board of directors.

Traditionally, the board of directors and other senior executives of the company were the owners themselves or they were agents controlled by the owners being the fiduciaries obligated by law to protect the interests of the stakeholders. With the advent of economic globalization, corporations have grown larger and have also started operating on a global basis. This has resulted in dilution of the control from the real owners of the business and has also enlarged the power and authority of the professional managers.

As Herman points out, ‘there has been a “managerial revolution” during the 20th century, characterized by a fundamental change in the control of the corporation moving from the owners to non-owning managers.’  ‘The relationship between the objectives of large corporations and their internal mechanisms concerning the division of power is important in analysing how large corporations may respond to actual and potential external demands and social controls.’


Kai – Alexander Heeren and Oliver Rieckers seriously doubt the ability of the Sarbanes – Oxley Act to substantially improve capital market conditions and the regulation of corporate governance dependent thereon. They opine ‘In the long-run it may even cause adverse effects for U.S. capital markets.’ The authors argue that it is for the legislator to decide whether it wants to ‘rely primarily on a strong internal corporate governance structure or if it wants to follow a more market-based approach.’

A study of recent US legislation shows that the country follows a hybrid approach to the provision and maintenance of a corporate governance framework. Such a combination of internal and external corporate governance elements will surely result in the US providing an overdose of the legislative response to corporate governance which may prove detrimental to the development of the economy. This is so because any overregulation runs the risk of making the regulation itself an inefficient one, and hence it is necessary that any hybrid approach like that adopted in the US should be properly balanced to be more effective and to ensure efficient functioning of the capital market.


  1. Dan Busbee, ‘Public Regulation and Private Business Conduct: A US Perspective on Good Corporate Governance’ in Corporate Governance Post – Enron: Comparative and International Perspectives: Studies in International Financial, Economic and Technology Law (British Institute of International and Comparative Law 2006)  236.
  2. Daniel Berkowitz, Katharina Pistor & Jean-Francois Richard, ‘Economic Development, Legality, and the Transplant Effect’ EUR. ECON. REV.  (2003) Vol. 47  165.
  3. Deborah A Demott, ‘Texture of Loyalty’ in Corporate Governance Post – Enron: Comparative and International Perspectives: Studies in International Financial, Economic and Technology Law (British Institute of International and Comparative Law 2006) 24.
  4. E S Herman, (1982) Corporate Control, Corporate Power: A Twentieth Century Fund Study Cambridge University Press  New Edition  4.
  5. F Macmillan, ‘Corporate Disclosure in the Era of Globalization’ in Rider, B A K, Tajima Y and Macmillan F (eds) Commercial Law in a Global Context ( London, 1998) 122.
  6. Financial Accounting Standards Board, Statement of Financial Accounting Concepts No 1 Objectives of Financial Reporting by Business Enterprises, para 37 (1978).
  7. JD Van Niel, ‘Enron—The Primer’ in NB Rapoport and BG Dharan Enron: Corporate Fiascos and Their Implications (Foundation Press 2004) 16.
  8. John C. Coffee Jr, ‘A Theory of Corporate Scandals: Why the USA and Europe Differ’ Oxford Review of Economic Policy 2005 Vol. 21 No 2, 199  < > accessed on 20th July 2007
  9. John J. Palter and James R. Leverette, ‘Filling the Stock Option Void’ Compensation Benefits Review 2006 Vol 38 No 50, 51 <>  accessed on 20th July 2000

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Us Corporate Scandals And Sarbanes – Oxley Act 2002. (2016, Aug 18). Retrieved from

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