Corporate Governance of the Financial Reporting Process (Portfolio 5506)

This Portfolio explains and analyzes federal corporate governance requirements for the financial reporting process.

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This Portfolio is part of the Accounting Policy and Practice Series, an essential resource including more than 70 accounting Portfolios and the latest news and developments.


This Portfolio explains and analyzes federal corporate governance requirements for the financial reporting process. Separately from principles of corporate governance under state law, federal law has developed a set of corporate governance principles, largely through investigations of financial reporting irregularities by the Securities and Exchange Commission (“SEC”). By explaining how this substantial body of relevant federal law has developed, the Portfolio enhances corporate directors' understanding of their responsibilities in the financial reporting process. The Portfolio also suggests ways that corporate directors may avoid running afoul of applicable law.
The requirements on which this work focuses are found primarily in the federal securities laws. The Portfolio discusses the federal corporate governance requirements for disclosure, the traditional guiding principle of federal securities regulation; certain procedural requirements, such as audit committee oversight of external auditors; and responsibilities of accountants and attorneys to report financial reporting problems up the corporate chain of command. In addition, the Portfolio identifies pertinent structural requirements under the federal securities laws, such as rules requiring director and Audit Committee independence. The foregoing requirements are generally well known to public companies and directors.
Perhaps less well recognized is the evolution of federal standards of performance for directors overseeing the financial reporting process. These standards have become more comprehensive and demanding than directors' state law fiduciary duties. The SEC sanctions directors for deliberate misconduct, reckless disregard of impropriety by management, and negligence in their oversight of corporate financial reporting and disclosure. By imposing sanctions for negligence, the SEC in effect has prescribed a duty of reasonable care for directors overseeing the financial reporting process. This Portfolio describes and analyzes the evolution of these federal performance standards.
The Portfolio also discusses an SEC investigative report called the Seaboard 21(a) Report, which offers potential regulatory leniency if a company under SEC investigation voluntarily cooperates with the agency. The criteria for leniency set forth in the report encourage public companies, among other things, to maintain a culture of compliance, the proper tone at the top, and sound internal controls. If a company wishes to avail itself of the potential for leniency, it should implement these measures. Consequently, the report exerts a strong influence on the corporate governance process.
Readers should appreciate that this Portfolio is intended first and foremost to be a practical aide to the directors and management of public companies, and not a traditional legal treatise. Consequently, the Portfolio is written in the vernacular as much as possible, and prioritizes comprehensibility for the layperson over technical legal considerations. This Portfolio should be cited as BNA Tax and Accounting Portfolio 5506-2nd, Wang, Corporate Governance of the Financial Reporting Process (Accounting Policy and Practice Series).


Leonard W. Wang, Esq.

Leonard W. Wang, J.D., B.A, (Economics and Political Science), University of Wisconsin-Madison. Mr. Wang is a former Assistant Director, Division of Enforcement, of the U.S. Securities and Exchange Commission. During a 22-year career at the SEC, Mr. Wang received the Chairman's Award For Excellence, the Stanley Sporkin Award, the Capital Markets Award and the Division of Enforcement Director's Award. Mr. Wang was also elected to Phi Beta Kappa, Phi Kappa Phi, the Order of the Coif and the editorial board of the Wisconsin Law Review, and is a member of the District of Columbia Bar and State Bar of Wisconsin. Mr. Wang may be contacted at

Table of Contents

Detailed Analysis

I. Focus, Scope and Objectives of Portfolio

Introductory Material

A. Traditional Sources of Law

B. Emergent Sources of Law

C. Portfolio Focus and Purpose

1. In General

2. Performance Standards for Directors

D. Portfolio Scope and Organization

II. State Law Principles of Corporate Governance

Introductory Material

A. Structure and Process of Governance

B. Substantive Principles of Corporate Governance

1. The Board's Responsibility for Information and Reporting Systems

a. Scope of the Board's Duty of Inquiry

b. The Need for Directors to Use Their Expertise

c. The Need For Directors to Be Independent

d. The Need to Consider Relevant Constituencies

e. The Need for Directors to Act When They Learn of Problems

2. Director Protection Under the Business Judgment Rule

3. Beyond the Business Judgment Rule: Insulating Directors from Personal Liability

a. Exculpation of Directors

b. Indemnification of Directors

c. Advances for Legal Expenses

d. Directors and Officers Liability Insurance

e. Summary of Protection for Directors

III. Federal Securities Laws Principles of Corporate Governance

Introductory Material

A. The Disclosure Requirements

1. Backgrounds of Management and Directors

2. Executive and Director Compensation

3. Ownership of Company Securities

4. Relationships and Related Transactions of Corporate Insiders

5. Proxy Solicitations

B. Structure and Process

1. The Board of Directors

2. The Audit Committee

3. Other Committees of Directors

4. Internal Structure and Processes Below the Board Level

a. Internal Audit

b. Code of Ethics

c. Equity Compensation Plans

d. Loans to Directors and Executive Officers

e. Whistleblowing

(1) Whistleblowing by External Auditors

(2) Whistleblowing by Attorneys

(a) The Carter and Johnson Case

(b) The Gutfreund Case

(c) Sarbanes-Oxley Rule

(d) The Isselmann Case

(e) Summary of Attorney's Duty to Blow the Whistle

C. Management Certifications of Financial Reports

1. Purposes of the Certification Requirements

2. SOX: Section 302 Certification

a. Section 302 Requirements

b. The Company's Internal Controls

(1) Creation of Disclosure Controls and Procedures

(2) Evaluation of Controls

c. Determination of Accuracy and Completeness

d. The Disclosures Required by the Certification Process

3. SOX: Section 906 Certification

D. Substantive Federal Requirements for Corporate Governance of the Financial Reporting Process

1. Foundational Pronouncements

a. Stirling Homex Corporation

b. Gould, Inc.

c. National Telephone Co., Inc.

d. Summation of Foundational Developments

2. Growing Concerns of the 1990s

a. The Cooper Companies

b. Orange County, California

c. The W.R. Grace Investigative Report

3. Enforcement Actions Against Corporate Directors

a. Cases Against Directors Involved in Wrongdoing

(1) SEC v. Arthur Toll, Bruce B. Edmondson, Gerald Levinson and Elliott S. Fisher

(2) Incomnet

(a) False Press Release

(b) Trading in Company Stock

(c) Liability of Incomnet Directors

(d) Incomnet's Contribution to the Evolution of the Law

(3) First Florida Communications, Inc. and Paul Richard Bell

(4) Asthma Disease Management, Inc. and Richard A. Manini

(5) Del Global Technologies Corp., Inc. and David Michael

(6) Safescript Pharmacies, Inc. and Curtis Borman

(7) Former Directors of Spiegel Inc.

(8) Summary Concerning Direct Involvement by Directors

b. A Director's Duty to Use His or Her Awareness

(1) Reid Rutherford

(2) Tyco International Ltd. and Frank E. Walsh, Jr.

(3) The Massachusetts Turnpike Authority and James Kerasiotes

(4) Heartland Advisors, Inc. and Hugh Denison

(5) Royal Ahold and Ture Roland Fahlin

(6) Tyson Foods, Inc. and Donald Tyson

(7) Fischer Imaging Corporation and Teresa Ayers

(8) First American Health Concepts, Inc. and John R. Behrmann

(9) Summary as to Director's Awareness

c. The Director's Duty of Vigilance

(1) John H. Hankins, Howard L. Peterson and John G. Guffey

(2) Michael Marchese

(3) Rudolph Peselman

(4) Charles M. Powell and Clifford C. Thygesen

(5) Louise A. Cummings

(6) Steven Angel

4. Summary of Federal Substantive Requirements for Corporate Governance of the Financial Reporting Process

E. Leniency: The Seaboard 21(a) Report

1. Background

a. Seaboard's Financial Reporting Problem

b. Company Response to the Problem

c. Seaboard's Reward for Cooperating

2. Policy for Leniency

a. Cooperative Measures

b. SEC Caveats

c. Importance of Timing

d. Nature of the Seaboard Prescriptions

e. Steps Toward Leniency Under the Seaboard Report

(1) Steps to Take Before the Investigation

(2) Steps to Take in Response to the Investigation

f. Impact of Seaboard 21(a) Report

F. Considerations from the Criminal Process

G. Summary of Federal Law Concerning Director's Duty of Vigilance

H. A Footnote About Shareholders and Influential Persons

1. Shareholders: Jason Galanis

2. Influential Person: Alan Casden

IV. Theories of Legal Liability

Introductory Material

A. Fraud Charges

1. Intentional or Reckless Fraud

2. Negligent Fraud

B. Nonfraud Charges

C. Aiding and Abetting Charges

D. Causing Violations

E. Relevance of One's State of Mind

V. Planning Points: Measures for Fulfilling Federal Responsibilities

Introductory Material

A. Which Directors Are Responsible?

B. What Is Reasonable Care?

C. What Should Be Done in the Ordinary Course?

1. Adequacy of Systems and Processes

2. Oversight of Executive Management

3. Compare Company Disclosures Against the Facts You Know

4. Be Mindful of the Interests of All Securities Holders

5. Be Alert to Management and Directorial Self-Interest

6. Be a Responsible Signatory

7. Do Not Rely Exclusively on Management

8. Pursue Red (and Yellow) Flags

9. Implementing the Seaboard Prescriptions in the Ordinary Course

D. Seaboard Measures to Take After the SEC Investigation Begins

E. Avoid Uncooperative Conduct

VI. Summary of Directorial Responsibilities and Planning Points

Working Papers

Working Papers


Worksheet 1 CEO and CFO Certifications of Financial Statements Under Section 302 of the Sarbanes-Oxley Act

Worksheet 2 In the Matter of Robert C. Guccione, Securities Exchange Act Rel. No. 34-51073 (Jan. 24, 2005)

Worksheet 3 Report of Investigation in the Matter of Stirling Homex Corporation Relating to Activities of the Board of Directors of Stirling Homex Corporation, Securities Exchange Act Release No. 34-11516 (July 2, 1975)

Worksheet 4 Report Pursuant to Section 21(a) of the Securities Exchange Act of 1934 Regarding the Investigation of Gould Inc., Securities Exchange Act Release No. 34-13612 (June 9, 1977)

Worksheet 5 Report of Investigation in the Matter of National Telephone Co., Inc., Relating to Activities of the Outside Directors of National Telephone Co., Inc., Securities Exchange Act Release No. 34-14380 (January 16, 1978)

Worksheet 6 Report of Investigation in the Matter of the Cooper Companies, Inc. as it Relates to the Conduct of Cooper's Board of Directors, Securities Exchange Act Release No. 34-35082 (December 12, 1994)

Worksheet 7 Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934 Concerning the Conduct of Certain Former Officers and Directors of W.R. Grace & Co., Securities Exchange Release No. 34-39157 (Sept. 30, 1997)

Worksheet 8 Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934 and Commission Statement on the Relationship of Cooperation to Agency Enforcement Decisions, Securities Exchange Act Release No. 44969 (Oct. 23, 2001)

Worksheet 9 In the Matter of Incomnet, Inc., Joel W. Greenberg, and Stephen A. Caswell, Securities Exchange Act Release No. 34-40281 (July 30, 1998)

Worksheet 10 In the Matter of John E. Backlund, John H. Hankins, Howard L. Peterson and John G. Guffey, Securities Act Release No. 33-7626 (Jan. 11, 1999)

Worksheet 11 In the Matter of Massachusetts Turnpike Authority and James J. Kerasiotes, Securities Act Release No. 33-8260 (July 31, 2003)

Worksheet 12 In the Matter of Ture Roland Fahlin, Securities Exchange Act Release No. 34-50519 (Oct. 13, 2004)

Worksheet 13 In the Matter of Tyson Foods, Inc. and Donald Tyson, Securities Exchange Act Release No. 34-51625 (April 28, 2005)

Worksheet 14 In the Matter of Michael Marchese, Securities Exchange Act Release No. 34-47732 (April 24, 2003)

Worksheet 15 Securities and Exchange Commission v. Chancellor Corporation, Brian Adley, Franklyn Churchill, David Vople, Jonathan Ezrin, Rudolph Peselman, Gregory Davis and BKR Metcalf Davis, CA No. 03-10762 (MEL)(D. Mass. April 24, 2003), Complaint

Worksheet 16 In the Matter of The Rockies Fund, Inc., Stephen G. Calendrella, Charles M. Powell, Clifford C. Thygesen, and John C. Power, Securities and Exchange Act Release No. 34-48590 (Oct. 2, 2003)

Worksheet 17 Securities and Exchange Commission v. Ocumed Group, Inc., Alfred Caggia, and Louise Cummings, C.A. No. 1:04CV00829 (D.D.C. May 24, 2004) Complaint

Worksheet 18 In the Matter of John E. Isselmann, Jr., Securities Exchange Act Release No. 34-50428 (Sept. 23, 2004)

Worksheet 19 SEC v. Cedric Kushner Promotions, Inc., et al., 417 F. Supp. 2d 326 (S.D.N.Y. 2006)

Worksheet 20 Remarks of SEC Chairman Christopher Cox, BNA Accounting Policy & Practice Report, Vol. 2, No. 3 (Feb. 10, 2006)

Worksheet 21 Sarbanes-Oxley Act § 302

Worksheet 22 Sarbanes-Oxley Act § 906




Court Cases

Federal Rules of Civil Procedure

U.S. Department of Justice Materials

U. S. Attorney's Manual


U.S. Securities and Exchange Commission Materials

SEC Regulations

SEC Forms


SEC Administrative Proceedings

SEC Reports

SEC Staff Bulletins and Staff Guidance


SEC Press Releases

SEC Litigation Releases

SEC Speeches

Emerging Issues Task Force

New York Stock Exchange

The Nasdaq Stock Market, Inc.

American Stock Exchange

State of Connecticut

State of Delaware

District of Columbia

State of Michigan

State of New York

State of Pennsylvania

State of Wisconsin


American Bar Association

Bureau of National Affairs, Inc.

News Media

The Wall Street Journal

The Washington Post