Some have expressed concern that many smaller to mid-sized public companies, those with low market capital or a recent decline in stock price, are hesitant to consider going private because of issues involving stringent regulatory requirements, increased regulatory scrutiny by the Securities and Exchange Commission (the "SEC"), and the high costs associated with going private. Although these are legitimate considerations in connection with going private, companies looking to effect a going private transaction should not be deterred from doing so by the legal regimen surrounding such transactions. Rather, the cost and regulatory burdens of going private transactions should be analyzed on an ad hoc basis and weighed against the long-term costs and public disclosure and compliance requirements of remaining a public company, as well as the potential long-term benefits of going private. These public companies should consider all the factors outlined below before deciding that going private is not beneficial to their company.
Going private is both a descriptive term for a transaction that results in the target company's ceasing to be publicly held and a technical term that describes a subset of those transactions involving affiliates of the company. This discussion is limited to the technical definition of going private transactions, which is any transaction that results in the company's ceasing to be an SEC-reporting company or, if it is an exchange-listed company or a company traded on an inter-dealer quotation system, ceasing to be so listed or traded.
Companies consider going private transactions for many reasons that benefit them in the long term, including eliminating the time and expenses associated with being public; managing the business with a long-term outlook and not being subject to the short-term focus of Wall Street; providing a defense mechanism against a hostile takeover attempt; operating the business without exposure to liability under SEC statutes and regulations; capitalizing on an opportunity in distressed market conditions to acquire the equity of the company; and managing the business in a more private way.
Many companies are discouraged from going private, however, because going private transactions trigger the SEC's going private rules. Such transactions are governed by Rule 13e-3, which requires detailed, expanded disclosures regarding the transaction, including the purposes of, reasons for, and alternatives to the transaction; whether the related part(ies) believe the transaction is fair to the unaffiliated stockholders and how they reached that conclusion; whether the company or the related part(ies) have received any reports or appraisals regarding the transaction; a statement of plans or proposals regarding the company's structure or business, including asset sales, post-transaction; if material, pro forma information for the company going forward; whether and why any of the company's directors disagreed with the transaction or abstained from voting on the transaction; and whether a majority of independent directors approved the transaction. The preparation of this disclosure can be an arduous task requiring management's collaboration. The SEC reviews all going private transactions rigorously and comments vigorously. In addition to the Rule 13e-3 filing and disclosure requirements, the transaction may be subject to other filing and disclosure requirements pursuant to other statutory provisions or rules of the SEC, such as those governing a third party tender offer or merger.
A going private transaction will also likely trigger heightened duties under applicable state corporate laws, typically leading the board to form an independent special committee of the board, with separate advisers, to consider the transaction and determine the fairness of the transaction to stockholders. Independent directors and committees are responsible for ensuring the fairness of the transaction and negotiating a higher price than offered, if necessary. To protect stockholders, some states have adopted corporate takeover provisions that entitle stockholders to dissenters' rights. Compliance with applicable state laws imposes on companies the cost of engaging legal counsel as well as independent investment bankers for valuation, stockholder dissenters' rights and possible stockholder derivative suits against the board and its committees. Moreover, the independent directors and committees typically retain their own separate counsel and engage their own independent financial adviser to issue a fairness opinion regarding the transaction.
The concern raised by going private transactions, under SEC rules and any applicable state laws, is that management, with its inside information and insight into the company, will attempt to buy the company from the public stockholders at a bargain price. The SEC addresses this issue by requiring additional disclosure. Applicable state laws address the issue by imposing stricter scrutiny on the board's discharge of its fiduciary obligations.
Concerns are also expressed with respect to the perceived increased litigation risk associated with the disclosures required by Rule 13(e)(3) and other elements of a going private transaction. It is true that a going private transaction does entail increased litigation risks, based upon claims of alleged breach of fiduciary duty, self-dealing by affiliates, inadequate consideration, deficient processes to protect the minority, and other grounds. It is also true, however, that public companies and their directors and officers are frequently sued, based upon alleged insider trading, violations of their fiduciary obligations, self-dealing, excessive compensation or other benefits, and for other reasons. The basis for such claims and the associated litigation risks would be eliminated by a going private transaction and, if properly structured, the transaction itself should survive scrutiny and should not invite meritorious litigation. Therefore, although the litigation risks incident to a going private transaction are greater than those that would exist in the absence of such a transaction, they are not materially greater than the litigation risks incident to remaining a public company, and the threat they present can be managed with proper advice and is of a finite duration.
Despite these obstacles to going private, smaller public companies should not be deterred from going private without first weighing all the long-term benefits and burdens described above against the benefits and burdens of remaining public. The high cost of disclosure and compliance of remaining a public company has recently been exacerbated by the Sarbanes-Oxley Act of 2002 (the "Act") as well as by recent rules proposed by the New York Stock Exchange and Nasdaq. Recent estimates of compliance with the Act range from $250,000 to $400,000, while the estimated cost of a going private transaction, including compliance with SEC Rule 13e-3, is $400,000. The Act imposes additional and perhaps unintended burdens on smaller public companies.
For example, the Act requires chief executive officers and chief financial officers of public companies to certify that a company's periodic reports are not misleading within the meaning of Rule 10b-5 under the Securities and Exchange Act, as amended (the "Exchange Act"), and that the financial information included in periodic reports "fairly presents" the financial condition of the company. Knowing violations may result in fines up to $1 million and imprisonment up to 10 years. Willful violations may result in fines up to $5 million and up to 20 years imprisonment. Because executives are now personally liable for the accounting practices of their companies, the cost of director and officer ("D&O") liability insurance has increased substantially, especially for smaller companies. Executives have increasingly found themselves named as defendants in stockholder suits, which have mushroomed post-Enron, Adelphia, WorldCom, etc. In addition, these requirements increase the cost of independent audits of a company's financial statements.
The Act also requires a company's audit committee to consist entirely of independent, unaffiliated directors who may not accept any compensation from the company other than compensation for being on the committee. Faced with these new requirements for board members and audit committees, smaller public companies are having to engage executive search firms to find new directors and financial experts for their boards and audit committees. Many smaller companies will find it difficult and expensive to recruit such experts, given the risks now associated with serving on an audit committee or as a director.
Also, the Act has shortened the deadlines for officers, directors and principal stockholders to report changes of beneficial ownership in reports required to be filed under Section 16(a) of the Exchange Act from as many as 40 days down to two business days following the day on which the change occurs. The SEC has also shortened substantially the deadlines for filing periodic reports on Forms 10-K, 10-Q, and 8-K. A smaller public company will spend significant money on outside attorneys and accountants to comply with accelerated filing and disclosure requirements.
There is no doubt that public companies face higher compliance costs as a result of the Act. The SEC so far has declined to exempt small business from any of the Act's requirements. The Act's increased level of regulation will cause smaller public companies without the compliance infrastructure of a large company to incur increased administrative, legal, and accounting fees to keep up with the new rules. These cost increases resulting from the Act's many requirements are high enough to have many smaller companies thinking about going private. Audit fees, legal fees, and D&O insurance premiums are expected to increase and costs could go higher as internal control regulations and accelerated financial statement filing requirements become effective. Compensation for outside directors is also expected to increase, as well as the cost for increased personnel to maintain compliance.
Traditionally, a primary reason for a company to go public was to gain access to investment capital in the public capital markets. The public capital markets are currently effectively closed for most small companies, so one of the main benefits of being a public company is now virtually erased. Additionally, years of down markets have driven down the market capitalization of many companies. At the same time, analyst coverage of small- to mid-cap companies is declining, making access to growth capital more difficult. When compounded with the current downturn in the public capital markets and the high cost of remaining public, the additional burdens of complying with the requirements of the Act highlight the need for certain smaller public companies to examine whether going private is right for them. All of these added complexities may make remaining public in the post-Act world too much to handle, and many smaller companies may find the prospect of being taken private a more attractive alternative.
Although going private is an expensive process involving extensive filings with, and increased scrutiny from, federal regulators and a potential for stockholder suits, once done it can save the company a lot of money, especially in light of the recent requirements of the Act, some of which have not yet been calculated. When these burdens are balanced against the ongoing burdens and costs of remaining public, going private may be the right thing for the right company, a fair deal for the public and a compelling value for the new owners.
Michael L. Jamieson is a Partner and Dino A. Doyle is an Associate in the Tampa, Florida office of Holland & Knight LLP. Both practice in the area of corporate and securities law in the firm's Business Law Section.