As we learned in the previous section, the corporation is governed by the board of directors, led by the chairman of the board. In most companies the chairman of the board is also the CEO or Chief Executive Officer of the company. During the three-year stock market collapse of 2000–2002, many companies went bankrupt due to mismanagement or in some cases, financial statements that did not accurately reflect the financial condition of the firm because of deception and outright fraud. Companies such as WorldCom reported over $9 billion of incorrect or fraudulent financial entries on their income statements. Many of the errors were found after the company filed for bankruptcy and new management came in to try and save the company.

Enron also declared bankruptcy after it became known that their accountants kept many financing transactions “off the books.” The company had more debt than most of their investors and lenders knew. Many of these accounting manipulations were too sophisticated for the average analyst, banker, or board member to understand. In the Enron case, the U.S. government indicted its auditor, Arthur Andersen, and because of the indictment, Andersen was dissolved. Other bankruptcies involving WorldCom, Global Crossing, and Adelphia also exhibited fraudulent financial statements. Because of these accounting scandals, there was a public outcry for corporate accountability, ethics reform, and a demand to know why the corporate governance system had failed. Why didn’t the boards of directors know what was going on and stop it? Why didn’t they fire management and clean house? These questions will be hot topics for discussion for many years.

The issues of corporate governance are really agency problems. Agency theoryThis theory examines the relationship between the owners of the firm and the managers of the firm. While management has the responsibility for acting as the agent for the stockholders in pursuing their best interests, the key question considered is: How well does management perform this role? examines the relationship between the owners and the managers of the firm. In privately owned firms, management and owners are usually the same people. Management operates the firm to satisfy its own goals, needs, financial requirements, and the like. However, as a company moves from private to public ownership, management now represents all the owners. This places management in the agency position of making decisions that will be in the best interests of all shareholders. Because of diversified ownership interests, conflicts between managers and shareholders can arise that impact the financial decisions of the firm. When the chairman of the board is also the chief executive of the firm, stockholders recognize that the executive may act in his or her own best interests rather than those of the stockholders of the firm. In the prior bankruptcy examples, that is exactly what happened. Management filled their own pockets and left the stockholders with little or no value in the company’s stock. In the WorldCom case, a share of common stock fell from the $60 range to $.15 per share and eventually ended up being worthless. Because of these potential conflicts of interest, many hold the view that the chairman of the board of directors should be from outside a company rather than an executive of the firm.

Because institutional investorsLarge investors such as pension funds or mutual funds. such as pension funds and mutual funds own a large percentage of stock in major U.S. companies, these investors are having more to say about the way publicly owned corporations are managed. As a group they have the ability to vote large blocks of shares for the election of a board of directors. The threat of their being able to replace poorly performing boards of directors makes institutional investors quite influential. Since pension funds and mutual funds represent individual workers and investors, they have a responsibility to see that firms are managed in an efficient and ethical way.

Sarbanes-Oxley Act

Because corporate fraud had taken place at some very large and high profile companies, Congress decided that it needed to do something to control corrupt corporate behavior. There were problems that needed correcting. The major accounting firms had failed to detect fraud in their accounting audits, and outside directors were often not provided with the kind of information that would allow them to detect fraud and mismanagement. Because many outside directors were friends of management and had been nominated by management, there was a question about their willingness to act independently in carrying out their fiduciary responsibility to shareholders. Congress has often over-reacted and created laws that have unintended consequences and so the jury is still out on the effectiveness of the Sarbanes-Oxley Act that Congress passed in 2002.

The act set up a five-member Public Company Accounting Oversight Board with the responsibility for auditing standards within companies, controlling the quality of audits, and setting rules and standards for the independence of the auditors. It also puts great responsibility on the internal audit committee of each publicly traded company to enforce compliance with the act. The major focus of the act is to make sure that publicly traded corporations accurately present their assets, liabilities, and equity and income on their financial statements.