The Disadvantages of Corporate Governance

By David Carnes

Corporate governance is one of the law's most intensely regulated fields. This is because corporations are privately owned but are treated as independent legal entities, rendering their assets vulnerable to a variety of potential abuses. Corporate governance is generally governed by state law, although the federal government has also enacted legislation to curb abuses.

Ownership-Management Separation

The officers and directors who run the day-to-day affairs of a corporation and make most of its policy decisions are not necessarily shareholders. This can become a problem in large, publicly traded corporations. If no shareholder holds a controlling interest in the corporation, and most shareholders vote by proxy, the corporation's assets are controlled by the board of directors and the officers. The separation of ownership and management can lead to a conflict of interest between management's duty to maximize shareholder value and its interest in maximizing its own income. A CEO, for example, might be paid a large bonus even as the corporation approaches bankruptcy.

Illegal Insider Trading

The term "corporate insiders" refers to corporate officers, directors and employees because they may have access to confidential, non-public information about the corporation that might affect the value of its shares. Corporate insiders are not strictly prohibited from trading corporate shares but must report these trades to the Securities and Exchange Commission. Illegal insider trading occurs when a shareholder, while in possession of confidential information relevant to the future value of his shares, sells shares to a buyer without access to this information. Illegal insider trading can also be committed by a shareholder not directly affiliated with the corporation, such as an outside auditor, a government regulator or a relative of a corporate insider. Because access to confidential corporate information can be widely dispersed, laws against insider trading can be difficult to enforce.

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Misleading Financial Statements

There are many ways to present factually accurate information on a financial statement in a manner that is misleading to investors -- by, for example, selling property from a parent company to a subsidiary to maximize parent company revenues. It is also possible to present factually incorrect information that is difficult to detect by establishing complex networks of subsidiaries and cross-shareholdings.

Costs of Regulation

The abuse of corporate governance has triggered the enactment of a large body of state and federal laws designed to prevent such abuses from recurring. Compliance with these laws can be burdensome and expensive for corporations. For example, the Securities and Exchange Act of 1933 requires companies seeking to list on a stock exchange to make such extensive disclosures to potential investors that compliance can cost hundreds of thousands of dollars. More recently, the Sarbanes-Oxley Act of 2002 requires corporations to establish extensive systems of internal controls to ensure that their financial statements are both factually accurate and non-misleading.

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