Corporate Governance and SOX Act Overview

Corporate Governance

• Corporate governance is the process of directing and controlling companies to ensure they act in the long-term best interests of stakeholders.
• It became prominent after the Enron and WorldCom scandals.
• The Sarbanes-Oxley Act (SOX Act) was enacted to strengthen corporate governance by focusing on board independence and improving financial reporting.
• It includes the appointment of independent directors detached from operational duties and without business dealings with the company.

Sarbanes-Oxley Act (SOX Act)

• The SOX Act is primarily a corporate governance regulation.
• It requires the evaluation of internal controls for reliable and transparent financial reporting.
• SOX enhances board independence, requiring more independent directors.
• It also includes oversight of audits of corporate financial statements, whistleblower policies, and transparent disclosures of financial and non-financial information.

OECD Definition of Corporate Governance

• The Organisation for Economic Co-operation and Development (OECD) defines corporate governance as a system of stewardship and control guiding organizations in fulfilling long-term economic, moral, legal, and social obligations towards stakeholders.

Stewardship and Control

• Management is responsible for day-to-day operations.
• Corporate governance involves oversight and monitoring of corporate performance and operating results, ensuring the business is run properly.
• This role is fulfilled by the board of directors.

Fulfillment of Obligations

• Corporate governance aims to fulfill long-term economic, moral, legal, and social obligations towards stakeholders, including investors, creditors, suppliers, employees, government regulators, and society.
  • Economic obligations include providing sufficient returns to shareholders through dividends.
  • Moral obligations include paying appropriate compensation to employees.
  • Legal obligations include complying with legal requirements and contractual obligations.
  • Corporate social responsibility is also a key objective.

Stakeholder Theory vs. Stockholder Theory

• Stockholder theory states that corporations exist for the benefit of shareholders.
• Stakeholder theory states that corporations exist for the benefit of all stakeholders, including employees, creditors, suppliers, government, and society.

Long-Term Sustainability

• The goal of corporate governance is to reconcile long-term customer satisfaction with shareholder value, benefiting all stakeholders and society.
• It aims to hold the board and senior management accountable for ethical behavior through regulations, performance standards, and ethical guidelines.

The Agency Problem

• The agency problem arises when managers (agents) use their authority for personal benefit, not the benefit of the owners (principal).
• This is common in companies with many shareholders, as direct management by all owners is impractical.
• Short-termism occurs when managers prioritize short-term profits over long-term growth.
• An example is self-dealing transactions where a manager benefits at the expense of the company, like an inflated purchase from their own business.

Solutions to the Agency Problem

• To ensure managers act in the best interests of owners, measures include:
  • External and internal audits
  • Board of directors oversight of managerial performance
  • Management compensation tied to corporate performance and/or stock price
  • Code of ethical conduct
  • Internal controls
  • Government regulation (e.g., Sarbanes-Oxley, SEC regulations)

Governance vs. Management

• Management handles day-to-day operations.
• Governance provides oversight and ensures alignment with long-term goals and stakeholder interests.