Part E â€“ Case Studies of Business Risks
Therefore when the Bill becomes law loans to directors will be permitted only
with the approval of the shareholders. Also compensation will not be granted
to a director on account of loss of employment without shareholdersâ€™ approval
(Clauses 171â€“204 of the Bill).
Transactions by directors with the company
Transactions or arrangements by directors with the company are not prohibited
(Clause 159 of the Bill). The directors are not required to take permission of
members or the board for entering into them. However, any interest the direct-
ors have in those arrangements or transactions must be disclosed unless an
exception applies (Clauses 161 and 165 of the Bill).
Directorsâ€™ dealings with third parties
Transactions with third parties are not prohibited unless the companyâ€™s object-
ives restrict them. In the Bill most of the conflicts of interests that may arise in
the context of directorsâ€™ dealings with third parties are permitted with the
authorisation of the board. However, such board authorisations are permitted
only when the director does not participate in decision making or â€“ if he par-
ticipates in the decision â€“ it would have been valid otherwise (Clauses 159 and
160 of the Bill).
In the UK it can be very difficult for shareholders to institute an action against
directors due to the costs of legal proceedings and the heavy burden of proof.
The law requires that the director is proved to have acted illegally or fraudulent
conduct on the part of directors must be established. The Bill will change this
by enabling shareholders to bring derivative suits against directors.
The general rule is that only the company can bring an action if some
wrong is committed to the company and not the shareholders. In reality it
is the directors who take the decision in this regard and not the sharehold-
ers. Therefore if the directors are the ones who do wrong to the company
the shareholders cannot do anything about it. This anomaly has been rec-
tified by the Bill which permits the court to entertain derivative actions by
shareholders by taking into account factors such as the true motive of the
shareholder, importance of the claim to the company and if shareholders in
their own right can bring a claim against the company. As a matter of fact
the court will have to put itself in the position of the independent director
to come to a decision whether it is prudent to pursue the derivative claim.
Chapter 21 â€“ UK corporate governance: reforms in the wake of corporate failures and the Enron case study 555
In the case where the decision of the director has been ratified by the
shareholder majority then the court cannot permit proceedings in such a
lawsuit (Clauses 239â€“243 deal with derivative actions stating the circum-
stances in which they can be brought).
In spite of the governmentâ€™s assurance that the change of law in this respect is
not major and its objective is not to adopt a US type class action â€“ there is con-
troversy over the possibility of an increase in the number of claims against
directors as to their negligence and breach of duty. This could be true without
having to prove fraud on minority. There is also discussion over how far the
minority shareholders will find it difficult to satisfy the court that they are act-
ing in the interests of the company or to enhance the success of the company.
In any case the shareholders will still be free to threaten the litigation in order
to influence the board and to pressurise the directors.
Moreover the shareholders will also be able to bring action for directorsâ€™
breach of duty in order to recover the money paid by the company for breach-
ing rules of listing, health and safety or environmental regulations. Any dam-
ages awarded in such actions will, of course, be made to the company.
The government has dropped a proposal providing for jail sentences for
directors who approve defective accounts: the maximum penalty will be an
unlimited fine. The FSA has been conferred the power to make or amend the
handbook rules. For example, amendments in the listing rules to implement EU
directives in relation to corporate governance applying to companies listed in
Under the Bill there are provisions relating to the audit. These include:
The limitation of the liability of the auditor firm (Clause 519 of the Bill);
Criminal liability for misleading the auditor as to companyâ€™s accounts
(Clause 494 of the Bill); and
Improperly influencing the auditorâ€™s report (Clause 489 of the Bill).
In essence the Bill is intended to overhaul company law by increasing share-
holder participation and codifying directorsâ€™ duties. It makes them clearer than
before, thereby providing for an efficient basis for corporate governance
(Accountancy Ireland, April 2006).
The above discussion demonstrates that the overall approach to corporate gov-
ernance in the UK has reduced the risk of a collapse of the type that occurred
in Enron. While the approach adopted so far has its critics, there is no doubt
that for an organisation to be successful in the UK, having regard to this frame-
work, it must take an increasingly enlightened view to both governance and
risk management. Bearing this in mind the comparative approach of the US is
considered in the next chapter.
Part E â€“ Case Studies of Business Risks
Useful web links
* Waring and Pierce (eds) (2005) The Handbook of International Corporate
Governance, Institute of Directors Publication, p. 167; http://www.
mazars.com/news/corporate_governance_gb.php accessed on 16-5-06.
* United Kingdom: The Company Law Reform Bill by Peter Bateman and
Simon Howley available at http://www.mondaq.com/article.asp?arti-
cleid 36286&hotopic 1 accessed on 29-4-06.
Legal risk management in the
US â€“ the United Statesâ€™ response to
the Enron collapse
Legal risk management in
22 the US â€“ the United Statesâ€™
response to the Enron collapse
In the previous chapter the UKâ€™s response to corporate failures was consid-
ered. The comparative approach of the US is explored in this chapter. The
United States reacted to the series of corporate debacles at the beginning of
this century â€“ and particularly Enron â€“ by reforming its corporate regula-
tory framework. In particular it:
* Reformed its corporate governance law by enacting the Sarbanes-Oxley
Act of 2002 (SOX); and
* Applied to listed companies rule changes proposed by the Security and
Exchange Commission and New York Stock Exchange (NYSE) and the
National Association of Securities Dealers Automated Quotation
System Stock Market (NASDAQ).
Therefore SOX is the key US legislative response to the Enron failure while
the recent corporate governance NYSE listing requirements also consist of
regulatory reform. Both legal and regulatory reforms aim to provide for more
independence of the board and the auditorâ€™s lack of oversight which played
a key role in the collapse of Enron (Elson, C. and Gyves, C. â€˜The Enron fail-
ure and corporate governance reformâ€™, Wake Forest Law Review Fall 2003,
92 GEOLJ 61). Traditionally in the US corporate law is under the jurisdiction
of the states and federal law has merely played a supporting role. However,
in the post-Enron corporate world corporate governance has become a col-
laborative process between federal law, state law and organisations which
are self-regulatory such as stock exchanges. In short it can be said that the
fall of Enron led to federalisation of American corporate law as discussed in
this chapter (see also Thompson 2003).
Sarbanes-Oxley Act (SOX)
In effect SOX brought about the federalisation of corporate law in the United
States. Prior to that case it had been a matter for the jurisdiction of states. In
Chapter 22 â€“ Legal risk management in the US â€“ the United Statesâ€™ response to the Enron collapse 559
particular it was the domain of the state of Delaware in so far as around 30 000
companies are incorporated in Delaware, including more than half of the 500
top fortune companies, and thereby under the jurisdiction of Delaware courts
(Delaware Business Central, available at web link at end of chapter). Set out
below are the key features of SOX.
One of the major reforms introduced by SOX was the creation of the Public
Company Accounting Oversight Board (PCAOB has been created under Section
101 of SOX). Its objective was to oversee accounting, thereby:
Providing for an independent audit committee;
Setting standards for corporate governance and responsibility;
Enhancing financial disclosure requirements;
Reducing the potential for conflict of interest; and
Introducing criminal punishments for fraudulent and misleading financial
reporting (Zolkos 2003).
In essence SOX brought an end to self-regulation of the accounting profession by
creating the PCAOB to oversee the profession. The PCAOB also has the respon-
sibility to further the public interest by ensuring that audit reports are independ-
ent and accurate. The registration of accounting firms is now mandatory
(Section 102 of SOX) and registered firms become subject to the auditing, qual-
ity control and independence standards set by the PCAOB (Section 103 of SOX).
Repercussions of Arthur Andersen conduct
It can be said that creation of the PCAOB is very effective to rein in the likes
of Andersen who have been criticised for compromising the standards of
the audit to serve their selfish interest. As a result of their role in the Enron
failure the PCAOB is to set standards for and discipline accounting firms.
The PCAOB is empowered to inspect (Section 104 of SOX) and conduct
investigations (Section 105 of SOX) if there is violation of SOX securities
law and the rules framed by it so that it is ensured that accounting firms
adhere to standards set for them to provide accurate and independent audit
reports. The PCAOB has been conferred power under SOX to punish erring
accountants and firms in case they do not comply with SEC rules (Pritchard
2006). The punishment can range from fines, limitations on activities, sus-
pension from audit functions on a temporary or permanent basis, censures
and removal from clientsâ€™ arrangements (Lucci 2003).
Conflict of interest: auditor independence
SOX deals with the problem of conflict of interest that arose in Enron as a result
of which Enronâ€™s auditors did not fulfill their responsibility of protecting the
Part E â€“ Case Studies of Business Risks
interest of investors and declaring the true financial condition of Enron. The
provisions of SOX prohibit auditors from providing nine types of non-audit
services (Section 201 of SOX). Those non-audit services that are not banned
under SOX will still need to be approved (Section 202 of SOX) by audit com-
mittee and disclosed to the public (Lucci 2003). The auditors are required
to report to the audit committee of the company for which they are performing
Critical accounting policies and practices affecting the financial statements;
Any accounting disagreement with management; and
All material written communications with management (Section 204 of SOX).
To maintain the independence of external auditors there is one more important
provision of SOX. This requires for the rotation of the lead partner and review
partner so that they are not auditing the company for more than five consecu-
tive years (Section 203 of SOX). This provision of rotation is to prevent auditors
from being too familiar and getting influenced excessively or captured by
Impact on auditors
Now auditors cannot be goaded or persuaded by greed to conceal the true
condition of their corporate client in fear of losing benefit they get from
providing non-audit services to it. In the case of Enron, the auditors,
Arthur Andersen, were providing non-audit services worth fees far in
excess of their audit fees. The conflict was that they did not want to lose
the consultancy fees in non-audit services. As a result they did not carry
out their responsibility towards investors. This cannot happen now.
SOX also changes the rules concerning the constitution of the audit committee.
Now the audit committee is constituted of independent directors only and is
directly responsible for hiring and firing of auditors. SOX also makes the audit
committee completely independent by such provisions and the requirement
that no fees can be accepted by its members other than by virtue of being a
member on the board of directors (Section 301 of SOX). Accordingly, the audit
committee is free of the influence and any sort of control of the management
Off balance sheet accounting
SOX requires the disclosure of off balance sheet transactions that have a mater-
ial effect on the current or future financial condition of the company (Section
401(a) of SOX). In Enron millions of dollars were concealed to give the impres-
sion of profitability leading investors to buy Enron shares. These new disclos-
ure requirements are to prevent off balance sheet transactions to hide losses
Chapter 22 â€“ Legal risk management in the US â€“ the United Statesâ€™ response to the Enron collapse 561
and present a strong financial state of the company to mislead investors (Kim,
B. â€˜Recent development Sarbanes-Oxley Actâ€™, Harvard Journal on Legislation,
Winter 2003). Now audit committees are entrusted with the role of overseeing
the corporationâ€™s financial reporting system and therefore have to play a crucial
part in the protection of interests of shareholders (Vera-Munoz 2005).
The CEO and CFO are required to certify the financial statement personally
and, in case of false certification, will be liable to face criminal penalties
(Section 302 of SOX). The criminal penalties are enhanced to deter erring execu-
tives to commit fraud on the company. Moreover, if the corporation files a
restatement of its finances the executives will forfeit the bonuses or profits
gained in that year through the sale of stock (Section 304 of SOX).