What Is SOX Corporate Governance?

Improve Company Governance Tighten Accounting Controls

Think back to the last great shock to our financial system. Major institutions failed to the shock of investors and depositors, uncertainty spread, and the availability of credit dried up even for the most highly rated borrowers. Ask yourself: what does SOX corporate governance have to do with any of that?

Quite a lot, as it turns out. The Sarbanes-Oxley Act was supposed to make financial reporting honest and internal controls real. This article explains what SOX corporate governance is, the agency problem it tries to solve, what the research actually shows, and the lessons every business can take from companies that treated controls as more than a compliance checkbox.

What Is SOX Corporate Governance?

Corporate governance became a mainstream concern after the Enron scandal in 2001 and the Sarbanes-Oxley (SOX) Act of 2002 that followed. Corporate governance is a wide-ranging term that describes the processes, policies, procedures, internal controls, laws, and institutions involved in guiding an organization toward long-term shareholder value (Khan, 2011). At its core, corporate governance is the set of methods outside shareholders use to protect themselves from inside managers (La Porta, Lopez-De-Silanes, Shleifer, & Vishny, 2000), a tension known as the agency problem.

Focus of Corporate Governance

The focus of corporate governance is, first, on ownership structure, investor protection, and return on investment (ROI) in order to maximize firm value and performance while moderating risk taking. Second, it is on the role of the board of directors, board performance, and board effectiveness, while overseeing CEO compensation and agency within an international governance environment. Research studies generally look at the impact of different corporate governance structures on managerial and organizational performance, though the results have been mixed (Larcker, Richardson, & Tuna, 2007).

Two board directors reviewing a shareholder return and ownership structure report

Prominent Corporate Governance Research

Corporate governance is a vast and well-researched topic. Searches on Google Scholar return millions of results for the term, with thousands of new papers added every year. Large industrialized countries are the focus of most empirical studies because of their easy access to data. Far less is known about countries with different legal and economic settings. Small markets, and especially emerging market economies, remain a significant weakness in the literature.

The most prominent research questions in the corporate governance literature revolve around agency theory, the theory of the firm, equity prices, and investor protection. Widely cited work in corporate governance includes:

Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure (Jensen & Meckling, 1976)
Corporate Governance and Equity Prices (Gompers, Ishii, & Metrick, 2003)
Investor Protection and Corporate Governance (La Porta et al., 2000)
Corporate Governance, CEO Compensation, and Firm Performance (Core, Holthausen, & Larcker, 1999)
What Matters in Corporate Governance (Bebchuk, Cohen, & Ferrell, 2009)
A Modest Proposal for Improved Corporate Governance (Lipton & Lorsch, 1992)
Corporate Finance and Corporate Governance (Williamson, 1988)
Stockholders and Stakeholders: A New Perspective on Corporate Governance (Freeman & Reed, 1983)
Financial Accounting Information and Corporate Governance (Bushman & Smith, 2001)
Corporate Governance, Board Diversity, and Firm Value (Carter, Simkins, & Simpson, 2003)

Key Corporate Governance Findings

The agency problem is a major area of research, where a professional manager may divert funds from the firm to themselves instead of returning them to investors. Bad corporate governance lets executive and director compensation packages diverge from shareholders’ interests while limiting shareholder control. Good corporate governance uses transparent rules and internal controls to align incentives among shareholders, directors, and managers, keeping firms competitive. Gompers et al. (2003) found that companies with strong shareholder rights beat the risk-adjusted stock returns of those with weaker shareholder rights.

Key corporate governance methods and controls discussed in the literature include:

Regulations: transparency, shareholder protection, limits to self-dealing, contracts, and documented SOX accounting policies and procedures
Ownership: dominant shareholders, shareholder activism, takeovers, and active boards
Compensation practices: incentive-based pay aligned with long-term performance
Stakeholder pressure: analysts, auditors, competition, credit monitoring, and internal controls
Informal governance measures: codes, reputation, social norms, and trust

Transparency and Due Diligence

The root cause of most financial blowups, one could argue, is a lack of transparency and due diligence. Lenders did not collect the proper information from the people they were lending money to. Buyers of packaged securities containing bad loans apparently did not really know what they were buying. Firms writing credit default swaps did not really know the viability of the institutions they were insuring, and did not have the capital to pay out should an institution fail. Without transparency and due diligence, lies and deception go unchallenged, particularly when people are being dishonest with themselves.

But wait a minute. Was not the Sarbanes-Oxley Act supposed to put an end to all that? Are not public companies, financial or otherwise, supposed to have an accounting internal control system in place, along with checks and balances to prevent unrealistic, overly optimistic projections and reporting? Although well intentioned, SOX has not been as effective as it should be at preventing fraud, abuse, and intentional ignorance. It also has not been as successful as hoped at encouraging organizations to implement effective financial internal control systems and improve corporate governance.

Auditor examining financial statements with a red pen and calculator at a desk

Proper Internal Controls

Transparency and due diligence are two positive results of a proper internal control system, which is exactly what the Sarbanes-Oxley Act requires. Some SOX requirements are simple and straightforward, such as the need for an independent auditor. The internal control system described in sections 302 and 404, however, seems to be little understood, and it is the cause of most of the confusion surrounding SOX. Yet this is the very provision of Sarbanes-Oxley that could have done the most to prevent the crisis.

An effective internal control system would have ensured that information provided by loan applicants was verified as accurate, and established that applicants had the means to repay the loan. It would have ensured due diligence and transparency among the investment banks and institutions buying mortgages bundled into investment securities, which obviously did not happen. It would also have required those selling default swaps to understand what they were insuring and to have the means to back them up.

Not only were meaningful financial control systems apparently ignored or misunderstood by those running many publicly traded companies, they were apparently ignored or misunderstood by auditors as well. Many of these companies, especially banks, had undergone several audits since Sarbanes-Oxley took effect. Can regulations like SOX be effective if the auditing systems meant to ensure compliance are not effective?

Finance manager presenting an internal controls framework chart to a small team

What Corporate Governance Questions Remain?

How do small equity markets affect corporate governance? In Denmark, some shareholders focus on environmental awareness or ethical behavior instead of firm profitability. In China, maintaining state control can matter more than firm profitability. Japan has relatively weak shareholder protections but a large equity market, while Italy, Germany, and France have weak shareholder protections and relatively small public equity markets (Elston, 2018). Little research has been done on emerging market economies (Li, Terjesen, & Umans, 2018), or on corporate governance using grounded theory. Studying how small equity markets affect corporate governance would deepen our understanding of how governance is shaped by alternative shareholder objectives.

Does Corporate Governance Work?

So, what is the verdict on SOX corporate governance? Are Sarbanes-Oxley regulations working? Not very well for the many publicly traded companies that did only the minimum in order to comply. For organizations that took the initiative to put effective, meaningful internal control systems in place and created a culture of transparency and due diligence, it is probably working much better.

Corporate Governance: What Lessons Can We Learn?

How well are internal control systems functioning in your business? Having an internal control system, whether for finance and accounting or for production, is not just about doing the minimum to comply with regulations like Sarbanes-Oxley or standards like ISO 9001. The goal of an internal control system is to improve an organization’s overall effectiveness and efficiency so it can achieve shareholder objectives across the whole organization: in finance, sales, design, manufacturing, and everywhere else.

When the only goal of an internal control system is compliance, you are doing the absolute minimum. Basic compliance at the lowest level does not really protect your investors, your employees, your customers, or your other stakeholders. Those banks and financial institutions that use an internal control system to continually improve and strengthen the organization are far more likely to be left standing when the financial world stops spinning. That is a lesson we should all take to heart, no matter what kind of business we are in.

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Corporate Governance References

Bebchuk, L., Cohen, A., & Ferrell, A. (2009). What Matters in Corporate Governance? Review of Financial Studies, 22(2), 783-827. doi:10.1093/rfs/hhn099
Bushman, R. M., & Smith, A. J. (2001). Financial accounting information and corporate governance. Journal of Accounting and Economics, 32(1-3), 237-333. doi:10.1016/s0165-4101(01)00027-1
Carter, D. A., Simkins, B. J., & Simpson, W. G. (2003). Corporate governance, board diversity, and firm value. Financial Review, 38(1), 33-53.
Core, J. E., Holthausen, R. W., & Larcker, D. F. (1999). Corporate governance, chief executive officer compensation, and firm performance. Journal of Financial Economics, 51(3), 371-406. doi:10.1016/s0304-405x(98)00058-0
Elston, J. (2018). Corporate governance: what we know and what we don’t know. Journal of Industrial and Business Economics, (46), 147-156. doi:10.1007/s40812-019-00115-z
Freeman, R. E., & Reed, D. L. (1983). Stockholders and stakeholders: A new perspective on corporate governance. California Management Review, 25(3), 88-106.
Gompers, P., Ishii, J., & Metrick, A. (2003). Corporate Governance and Equity Prices. The Quarterly Journal of Economics, 118(1), 107-156. doi:10.1162/00335530360535162
Jensen, M. C., & Meckling, W. H. (1976). Theory of the firm: Managerial behavior, agency costs and ownership structure. Journal of Financial Economics, 3(4), 305-360. doi:10.1016/0304-405x(76)90026-x
Khan, H. (2011). A Literature Review of Corporate Governance. Paper presented at the 2011 International Conference on E-business, Management and Economics.
La Porta, R., Lopez-De-Silanes, F., Shleifer, A., & Vishny, R. (2000). Investor protection and corporate governance. Journal of Financial Economics, 58(1-2), 3-27. doi:10.1016/s0304-405x(00)00065-9
Larcker, D. F., Richardson, S. A., & Tuna, I. R. (2007). Corporate Governance, Accounting Outcomes, and Organizational Performance. The Accounting Review, 82(4), 963-1008. doi:10.2308/accr.2007.82.4.963
Li, H., Terjesen, S., & Umans, T. (2018). Corporate governance in entrepreneurial firms: a systematic review and research agenda. Small Business Economics. doi:10.1007/s11187-018-0118-1
Lipton, M., & Lorsch, J. W. (1992). A modest proposal for improved corporate governance. The Business Lawyer, 59-77.
Williamson, O. E. (1988). Corporate Finance and Corporate Governance. The Journal of Finance, 43(3), 567-591. doi:10.1111/j.1540-6261.1988.tb04592.x

Frequently Asked Questions

What Is SOX Corporate Governance?

SOX corporate governance is the set of processes, internal controls, and accountability rules that public companies follow under the Sarbanes-Oxley Act of 2002. It exists to protect investors by making financial reporting accurate, transparent, and verifiable.

Why Did the Sarbanes-Oxley Act Become Necessary?

The Sarbanes-Oxley Act was passed in 2002 after the Enron scandal and a wave of accounting failures destroyed shareholder value and investor trust. Congress responded by requiring stronger internal controls, independent audits, and direct executive accountability for financial statements.

What Do SOX Sections 302 and 404 Require?

Section 302 makes senior executives personally certify the accuracy of financial reports. Section 404 requires management and external auditors to assess and report on the effectiveness of internal control over financial reporting.

How Does Good Corporate Governance Reduce the Agency Problem?

The agency problem arises when managers act in their own interest instead of the shareholders’ interest. Good corporate governance uses transparent rules, incentive alignment, and internal controls to keep directors and managers accountable to the owners of the firm.

Is Compliance With SOX Enough on Its Own?

Compliance is the floor, not the goal. Companies that treat internal controls only as a box-ticking exercise do the minimum, while those that use controls to improve effectiveness and efficiency build a genuine culture of transparency and due diligence.