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Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Corporate Governance

What it is:

Corporate governance is the process and rules under which a company is managed on the behalf of shareholders and stakeholders. The board of directors is primarily responsible for applying and maintaining a company's corporate governance.

How it works (Example):

Corporate governance is all about ensuring that companies act in the best interests of their owners -- the shareholders -- who have invested their savings, their children's college funds or their retirement funds in the company. Corporate governance is also about considering the interests of other entitites impacted by the company -- employees, the environment and even communities.

Corporate governance is not just a set of ideas or value statements. There are a significant number of very technical legal requirements that companies must follow in order to demonstrate that they have good corporate governance. In particular, the Sarbanes-Oxley Act, officially named the Public Company Accounting Reform and Investor Protection Act of 2002, introduced new governance standards for board conduct to ensure that directors are aware of and accountable for the financial condition of the companies they manage. All companies, foreign and domestic, that have registered equity or debt securities under the Securities Exchange Act of 1934 are subject to the 2002 act. Foreign public accounting firms must also comply with the Sarbanes-Oxley Act if they perform work for companies subject to the act.

This is most evident in the Sarbanes-Oxley Act's requirement that the board of directors of most public companies have an audit committee, which must appoint, inspect, regulate and control the actions of the company's auditing firm. Additionally, the CEO and CFO of any company subject to the Sarbanes-Oxley Act must certify in writing that the company's financial disclosures comply with the law and fairly represent the company's condition. The CEO and CFO also must certify that they have inspected the company's internal financial controls. To prevent directors and officers from issuing misleading financial statements in order to obtain personal benefits, the Sarbanes-Oxley Act makes it a federal crime for a company officer to pressure or manipulate an auditor into rendering a company's financial statements misleading. Further, if a company is forced to restate its financials, in most cases the CEO and CFO of the company must give back any bonuses, compensation or profits made on personal trades of the company's securities during the year after the faulty documents initially were disclosed.

To discourage deceptive compensation practices, the Sarbanes-Oxley Act outlaws most kinds of loans to company directors and officers and prohibits officers and directors from trading their company's securities during periods when other employees or retirement-plan participants may not. In addition, any changes in ownership by those owning at least 10% of the company's stock now must be publicly disclosed within two business days.

As part of its eye toward reforming corporate governance, the act toughened the consequences for financial misconduct. Violations of the act can range from censure to prison sentences and multimillion-dollar penalties. The Securities and Exchange Commission (SEC) has the authority freeze any payment to an officer, director, partner or agent during an investigation.

Why it Matters:

One of the most important goals of corporate governance is to ensure that company directors and officers are aware of and accountable for the financial condition of the companies they manage. The board of directors lays at the heart of the notion of corporate governance -- it has a fiduciary duty to the shareholders. This can be difficult, especially when the vast majority of information boards receive about corporate performance comes from management, but nevertheless, the board is ultimately responsible for the integrity of a company's financial statements and internal controls.

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