In the two years since its passage, the Sarbanes-Oxley Act ("SOX") has come to be seen as the most significant change in securities regulation since the enactment of the Securities Exchange Act of 1934 (the "Exchange Act"). SOX and related rules issued by the Securities and Exchange Commission (the "SEC") have fundamentally changed public companies' corporate governance systems. Many private companies are now debating whether they would benefit from adopting many corporate governance reforms mandated for public companies.
Most SOX provisions apply only to public companies. However, as we describe in this article, there are several reasons we believe it makes good sense for private companies to learn about the effects, and consider voluntarily complying with some of the requirements, of SOX.
Stakeholders may demand compliance with SOX. As a result of the heightened scrutiny directed to corporate governance practices at all companies, venture capital investors, lenders, and insurers are focusing greater attention on compliance by private companies with significant portions of SOX. Recent academic studies have suggested that public corporations implementing good corporate governance programs produce improved returns to investors. As a result, increased consideration is being given to the independence of board members and the establishment of audit committees, compensation committees and governance committees of the board, as well as compliance with other sections of SOX as described below.
Pre-IPO governance implementation may help smooth the IPO process. Because some provisions of SOX and its implementing rules will take time and careful planning to implement, such as the establishment of a code of conduct and ethics, private companies considering an initial public offering will be well served by learning about those provisions far in advance of an initial public offering. While both The Nasdaq Stock Market, Inc. ("Nasdaq") and the New York Stock Exchange, Inc. (the "NYSE") will allow newly listed companies a grace period, as described below, with respect to the independence and composition requirements for boards and their committees, many of the listing requirements set forth in Nasdaq's and the NYSE's revised rules take effect immediately upon listing. Moreover, many of the requirements of SOX, such as the prohibition on loans to executive officers and directors, will take effect immediately upon the filing, as opposed even to the effectiveness, of the first registration statement under the Securities Act.
Possible beneficial impact to potential acquirors. A public company acquiring private companies will need to quickly assimilate these companies into its corporate governance framework. Evidence that the private company has adopted certain corporate governance guidelines, such as reviewing the adequacy of its internal financial controls, will help provide an additional level of assurance to an acquiror.
Possible beneficial effect in an analysis of compliance with fiduciary duties. We believe that a court would favorably view efforts by a board of directors to implement sections of SOX, and good corporate governance practices in general, in any examination of the exercise by a board of directors of its fiduciary duties of care to the corporation. The duty of care owed by the directors of a Delaware corporation requires directors to act with such care as an ordinarily prudent person in a like position would use under similar circumstances, and in a manner that the director believes to be in the best interests of the corporation. This means that, in taking any action with respect to the corporation, the board must take the time to become informed with respect to all material elements of a proposed transaction, and be satisfied that it has been given all relevant information in connection with its decision. We believe that, for the board of directors of a private company, implementing elements of good corporate governance practices as reflected in SOX will serve the directors well in any examination of their fulfillment of their duty of care.
Beneficial effect on director and officer liability insurance premiums. We understand from the director and officer liability insurance industry that underwriters of that form of insurance take the corporate governance practices of companies into account in determining what premiums to charge for director and officer liability insurance, and for new clients, whether or not to underwrite a policy at all.
Some provisions of SOX do apply to private companies. These provisions include penalties for destruction of documents with the intent to impede or obstruct a federal investigation; and enhanced penalties for securities fraud and other white-collar crimes, such as mail and wire fraud.
Which Provisions Of SOX Should Private Companies Consider Complying With Now?
Although SOX does not require private companies to comply with the following provisions, these provisions are increasingly being adopted by private companies in response to the demands of investors, lenders and other interested parties.
Board of Director Independence. Both Nasdaq and the NYSE have recently adopted changes to their listing rules that will require issuers to have a majority of independent directors on their boards of directors, using stricter standards of independence.
Nasdaq will not consider a director to be independent if he or she had been employed by the company or its subsidiaries during the current year or any of the past three years, received payments of more than $60,000 from the company during the current year or any of the past three years (other than for service on the board or other limited exclusions), or had a family member who served as an executive officer of the issuer during any of the past three years, among other disqualifying factors.
Companies should consider the recruitment of independent directors well before the planning process for an IPO begins, since the heightened standards for independence and the increased responsibilities of board members following passage of SOX have made qualified board members even more challenging to find. Both Nasdaq and the NYSE require companies listing in conjunction with their initial public offering to have a majority of independent board members within 12 months of listing. Further, for any committees that are required to consist solely of independent directors (such as the audit committee, described below), companies must have one independent member at the time of listing, a majority of independent members within 90 days of listing, and all independent members within one year.
Audit Committee. Private companies considering an initial public offering should elect an audit committee consisting solely of independent directors, one of whom would ideally have experience preparing, auditing, analyzing or evaluating the financial statements of a similar entity. Under SOX and the newly revised listing standards of Nasdaq and the NYSE, more stringent standards of independence will be applied to members of the audit committees of public companies than will apply to other independent directors. For example, under Section 301 of SOX, no member of the audit committee may accept any consulting, advisory or other compensatory fee from an issuer, except for fees received in connection with his or her service on the board of directors or a committee of the board.
The audit committee should also adopt a written charter that outlines its role and responsibilities, including meeting at least quarterly with management and the company's outside auditors to discuss and review reports regarding the company's financial situation and financial reporting practices, and to review any financial reports to securityholders; establishing procedures to handle anonymous complaints of whistleblowers regarding accounting, auditing and other matters; hiring and approving the fees to be paid to the outside auditors; and approving related-party transactions involving management or directors and the company.
Compensation Committee. The NYSE now requires its listed companies' boards of directors to establish a compensation committee to set and approve compensation for the executive officers of the issuer. Nasdaq's revised listing rules do not require a separate board committee to address compensation decisions, but do require those decisions to be made either by the independent members of the board of directors or by a committee of independent directors. Companies (particularly with outside or employee investors) may wish to consider establishing a compensation committee to address such matters.
Nominating and Governance Committee. Similar to the requirements for compensation committees, Nasdaq will allow decisions relating to nominations and corporate governance issues to be addressed either by a committee of independent directors, or by the independent directors. NYSE will require such decisions to be made by a separately established committee of independent directors.
Many private, venture-backed companies find it impracticable or unnecessary to have a nominating committee that is charged with selecting and nominating directors at any time before they go public, given the various rights to board representation set forth in their charter and other governing documents. However, private company boards may wish to consider constituting a separate governance committee, the responsibilities of which could be expanded to include nominating decisions once the company becomes public. The responsibilities of a governance committee typically include overseeing the implementation of corporate governance policies and procedures, including whistleblowing policies, codes of conduct and ethics, insider trading policies, and other internal codes; and reviewing general business practices, particularly as they relate to preserving the company's good reputation in the community.
What Other "Best Practices" Should Private Companies Consider Adopting Now?
Codes of Conduct and Ethics. Section 406 of SOX and newly adopted listing rules issued by Nasdaq and the NYSE require all public companies to adopt a code of conduct and ethics. The SOX required code is only required to apply to a company's senior executive and financial officers, while the code required by Nasdaq and NYSE listing rules will apply to all employees of a listed company. In both instances, the code must include provisions relating to compliance with applicable governmental rules and regulations; honest and ethical conduct, including ethical handling of conflicts of interest; and full, timely and accurate disclosure in periodic reports filed with the SEC.
Relationship with Auditors. Public companies' relationships with their auditors have fundamentally changed as a result of SOX. In addition to establishing a new regulatory body to regulate activities of all public accounting firms that perform audits of publicly traded issuers, SOX also prohibits public accounting firms from providing several types of services for their audit clients. This provision will prevent issuers from using the same accounting firms that they use for the audits of their financial statements from providing most services other than accounting services. SOX also requires public companies to have their audit committees pre-approve any additional services to be provided by the auditors.
Under rules adopted by the SEC, an auditing firm will not be considered independent from an issuer if any former lead or concurring audit partner or other member of the issuer's audit engagement team has been hired by the issuer to serve in a position involving direct oversight over the preparation of the issuer's financial statements within the prior year.
While private companies are not required to establish similar rules, a private company should consider the benefits to stockholders of adopting practices that mirror these independence rules. In particular, public companies looking to acquire a private company may view with heightened scrutiny the audited financial statements of a private company that also pays its auditors to provide significant other services.
Loans to Executive Officers and Directors. Effective July 30, 2002, with certain narrow exceptions, Section 402 of SOX prohibits all public companies from directly or indirectly extending or maintaining credit, arranging for the extension of credit, or renewing extensions of credit, in the form of a personal loan to or for any director or executive officer of the issuer. Public companies may keep in place loans that existed prior to July 30, 2002, but those loans may not be renewed or materially modified.
The SEC and Congress have both declined to provide any express guidance, other than the express language of the statute, to help companies and their advisors determine what types of arrangements will be considered permissible under Section 402. In light of this, in order to assist companies with interpreting the statute, several law firms, including Mintz Levin, drafted a document that attempts to analyze the effect of Section 402 on some commonly used arrangements between companies and their officers and directors. In this document, arrangements such as advances of business travel and similar expenses, reimbursed use of a company credit card for minor personal expenses, reimbursed personal use of a company car, indemnification advances under charter and by-law provisions, and retention bonuses that are subject to repayment if an employee leaves a company are identified as likely to be permissible.
This section of SOX does not allow any "grandfathering" of loans made by private companies to their officers and directors before they became public companies, unless the loans were in effect prior to July 30, 2002. Accordingly, a private company should consider finding ways to compensate its officers and directors in ways that do not involve extensions of credit, because the company would immediately be in violation of Section 402 of SOX if it maintains post-July 30, 2002 loans to insiders on the date it files its first Securities Act registration statement. Further, simply as a matter of good corporate governance policy, investors and others now prefer not to see significant loans to insiders on a company's records.
Document Retention Policies. One of the criminal provisions of SOX, which applies to all companies whether public or private, states that it is a crime to "knowingly alter, destroy, mutilate, conceal [or] cover up...any record, document or tangible object with the intent to impede, obstruct, or influence" any federal investigation. As was amply demonstrated in the investigation and subsequent conviction of Andersen for its role in destroying documents related to the Enron matter, the failure to employ and properly implement and manage an adequate document retention policy can have extreme consequences. Companies should consider establishing document retention policies that are specifically tailored to their businesses in order to avoid any issues with respect to document retention or destruction in any lawsuit or investigation.
In summary, private companies may benefit from the voluntary implementation of certain provisions of SOX and the Nasdaq and NYSE listing requirements, both in order to prepare for an eventual public offering of their securities and in order to demonstrate to stakeholders and potential acquirors that they are aware of the importance of strong corporate governance principles. In this new world of scrutiny of corporate governance practices, these steps can help private companies move more quickly down the road to an IPO or sale of a private company while also providing additional assurances to existing investors that their investment is more secure.
Neil H. Aronson and Megan Gates are Partners in the Boston office of Mintz, Levin, Cohn, Ferris, Glovsky & Popeo, P.C.