While the last few years were a bit sluggish for IPOs, there has recently been a revival. In fact, there were more than 250 IPOs in 2004, which more than tripled the number of IPOs in 2003.1 We have suggested that often the most difficult decision that a private company must make is not whether to go public, but when.2 Due to the variety of corporate scandals over the past few years, prompting the adoption of the Sarbanes-Oxley Act of 2002 ("SOX") and other corporate governance rules, the regulatory burdens and public expectations placed upon public companies have never been greater. Since timing is such a crucial element in the IPO process, companies must ensure that they are ready to launch when the window of opportunity opens for them. This article discusses some of the more recently adopted requirements that a private company must observe if it goes public and what can be done in advance to help ease the burden associated therewith.
In order to "go public," a private company must typically file a registration statement on Form S-1 (or Form SB-2, if it is a small business issuer) under the Securities Act of 1933, the preparation of which involves significant time and effort on the part of a large working group. The Form S-1 must contain, among other information, detailed information regarding the company's business, the risks involved in investing in its stock, management's analysis of the company's financial condition and results of operations, use of proceeds, dilution, executive officers and directors, executive compensation, certain relationships involving conflicts of interest, related party transactions and principal stockholders. Depending on the company, most of this information will likely be first compiled in connection with the Form S-1 and drafted from scratch. In addition, the company must include audited financial statements for the last three fiscal years and unaudited financial statements for any interim period. If the company has recently acquired another business, it may also be required to include financial statements for such business as well as pro forma combined financial information.
After a potentially lengthy SEC review process, the Form S-1 can be declared effective and the IPO can proceed. Following the IPO, the company will be subject to the periodic reporting and, in most cases, the proxy, insider trade reporting and short-swing profit liability provisions of the Securities Exchange Act of 1934. If listing on the New York Stock Exchange, the American Stock Exchange or the Nasdaq Stock Market is desired, it will be required to prepare the applicable listing application. Each of these organizations has different quantitative and qualitative criteria for listing and continued listing, including substantive corporate governance requirements, which have been greatly enhanced in recent years.
Compliance With SOX
Generally. In addition, the company will be subject to the full panoply of SOX's requirements and prohibitions. Under SOX, each public company is:
Financial Statements. Public companies are required to file with the SEC annual financial statements that must be audited by an independent public accounting firm in accordance with the standards set forth by the SEC and the Public Company Accounting Oversight Board ("PCAOB"), a non-profit corporation established pursuant to SOX to promulgate auditing standards and register and regulate accountants. In the current environment, a financial statement audit has become a significantly more comprehensive process, a concern that is compounded by the current demand on auditor resources. Therefore, private companies that do not have their financial statements audited on an annual basis should strongly consider engaging an independent public accountant to audit the necessary financial statements well before launching an IPO. The company's principal executive and financial officers, usually the CEO and CFO, must certify the accuracy of the financial statements.5
Internal Controls. Perhaps the hottest topic among public companies and auditors over the last year or so has been compliance with SOX Section 404 and the rules promulgated thereunder. Section 404(a) mandated the SEC to adopt rules requiring an issuer to include in each annual report on Form 10-K a report of management regarding its assessment of the issuer's internal controls. Section 404(b) requires the issuer's independent accountants to attest to management's assessment of the issuer's internal controls pursuant to standards required to be adopted by the PCAOB. In June 2003, the SEC adopted its rules under Sections 404(a) and 404(b).6 In June 2004, the SEC approved PCAOB Auditing Standard No. 2,7 which sets forth the standards for an independent auditor's audit8 of internal controls.
The practical effect of these rules is that public companies are now required to adopt internal controls and report annually on the effectiveness of the design and implementation thereof.9 The overwhelming majority of public companies would likely agree that they have expended a tremendous amount of effort and money to comply with these internal control requirements. Indeed, we anticipate that a number of issuers will not be able to do so by the applicable deadline.10 Similar to the certification of financial statements, the company's principal executive and financial officers must certify as to the implementation, and based upon their assessment, the effectiveness of internal controls.11
As we have discussed in the past,12 the consequences of having ineffective internal controls may be far-reaching. Therefore, it is imperative that a private company seeking to go public establishes, prior to launching an IPO, a system of internal controls that is substantially compliant with the requirements imposed on a public company. Furthermore, underwriters and prospective new independent directors may take comfort in the fact that the issuer is on-board with the new requirements, thus reducing the possibility of the Form S-1 or subsequent periodic reports containing a material misstatement or omission. The underwriter may even require the issuer to represent and warrant as to the effectiveness of the issuer's internal controls in the underwriting agreement.
Disclosure Controls. Although there has been much confusion about the precise scope of "disclosure controls and procedures," they differ from internal controls over financial reporting in their purpose. Unlike internal controls over financial reporting, which are aimed at the accuracy of the financial statements, disclosure controls are designed to ensure that all information, quantitative or qualitative, required to be disclosed by an issuer in its Exchange Act reports is accumulated and communicated to the issuer's management to allow timely decisions regarding required disclosure thereof. While not as burdensome as establishing internal controls, establishing disclosure controls does require a significant amount of organization and effort. Private companies considering going public should consider forming a disclosure committee prior to launching an IPO. A disclosure committee and effective disclosure controls, in general, will also prove useful during the Form S-1 drafting and diligence process. The company's principal executive and principal financial officers will also be required to certify as to the effectiveness of the issuer's disclosure controls as of the end of the period covered by each periodic report.13
Audit Committees. SOX Section 301 (and listing criteria as to listed public companies) requires each public company to establish an audit committee comprised of independent directors. Although the standard for director independence is different under each applicable requirement, the term generally refers to a director who receives compensation (direct or indirect) from the company only in his or her capacity as director. The audit committee is responsible for, among other things, hiring, firing and supervising the company's independent public accountants and establishing procedures for the receipt and consideration of complaints of improper accounting. Companies should strongly consider appointing an "audit committee financial expert" to the committee.14 Because of the time and effort that it could take to recruit qualified individuals for the audit committee, including an audit committee financial expert, private companies should consider forming, or at least begin the process of forming, an audit committee satisfying the applicable regulatory requirements prior to launching an IPO.
Code of Ethics. SOX Section 406 directed the SEC to issue rules requiring companies to disclose whether or not they have adopted a code of ethics for senior financial officers and, if they have not adopted such a code of ethics, the reasons for such inaction. Under the rules adopted by the SEC, the code of ethics must apply to the principal executive officer, principal financial officer, principal accounting officer or controller and persons performing similar functions. While adoption of a code of ethics is not required, it is strongly recommended because absence thereof could result in negative public relations and investor opinion.
Loans. It is not uncommon for private companies to make loans to their directors and officers. Prior to SOX, it was not uncommon for public companies to do so. However, subject to a handful of exceptions, public companies are also prohibited, under SOX Section 402 from loaning funds or extending credit to a director or officer.15 The prohibition is inapplicable to loans already existing upon the enactment of SOX, but does apply to any modifications or renewals of such loans thereafter. To avoid inadvertent violation and to further their public relations efforts, many public companies have sought repayment of outstanding loans to directors and officers created prior to SOX, despite the lack of a legal imperative to do so. A company contemplating going public should review its arrangements with its directors and officers with the awareness that even transactions that are not traditional loans such as an advance of expenses might be construed by the SEC as a loan. Of course, any such arrangements would be required to be disclosed in the Form S-1.
In addition to the topics discussed in this article, a private company should also consider addressing a myriad of other issues in anticipation of going public.16 These include, among other things, securing employment agreements with key management personnel, safeguarding the company's trade secrets and other intellectual property rights, structuring executive compensation, including any revisions to stock option plans necessitated by the IPO, preservation and verification of title to corporate assets, adjustments to cheap stock, treatment of restricted stock and compliance with any covenants under existing debt agreements limiting the pursuit of additional capital.
Addressing these and the other issues mentioned in this article prior to launching an IPO will certainly help smooth the transition of going from private to public, and is sure to be a worthwhile exercise.
1 Investor's Business Daily, December 20, 2004.
2 See our article entitled "Be Prepared, the IPO Market Will Return" in the March 2002 issue of The Metropolitan Corporate Counsel.
3 "Internal control over financial reporting" is defined in Rules 13a-15(f) and 15d-14(f) under the Exchange Act.
4 "Disclosure controls and procedures" is defined in Rules 13a-14 and 15d-14 under the Exchange Act.
5 Required by Rules 13a-14(a) and 15d-14(a) under the Exchange Act.
6 See SEC Release No. 33-8238 (June 5, 2003).
7 See SEC Release No. 34-49884 (June 17, 2004).
8 An independent auditor's audit of the issuer's internal controls may only be performed in conjunction with its audit of the issuer's financial statements.
9 Note that public companies have long been required to maintain internal controls pursuant to the "accounting provisions" of the Foreign Corrupt Practices Act.
10 For companies who are "accelerated filers" under Exchange Act Rule 12b-2 as of the end of their first fiscal year ending on or after June 15, 2004, the applicable deadline is the filing of the Form 10-K for 2004, due on March 16, 2005. A company that is not an "accelerated filer" as of the end of its first fiscal year ending on or after June 15, 2004, including a foreign private issuer, must begin to comply with the annual internal control report for its first fiscal year ending on or after April 15, 2005.
11 Required by Rules 13a-14(a) and 15d-14(a) under the Exchange Act.
12 See our article entitled "Ineffective Internal Controls: Issues that Public Companies May Face After Receiving a Negative Report - Part II" in the November 2004 issue of The Metropolitan Corporate Counsel.
13 Required by Rules 13a-14(a) and 15d-14(a) under the Exchange Act.
14 Under amendments to Form 10-K promulgated by the SEC to implement Section 407 of SOX, public companies must disclose whether or not their audit committee has at least one "audit committee financial expert", as defined in Item 401(h)(2) of Regulation SK, and, if it does not, it must disclose the reasons therefor. Failure to have an audit committee financial expert on the audit committee may call the committee's judgment and competence into question, and may result in the stockholders withholding votes for the reelection of audit committee members.
15 The exceptions, which are for various types of loans including consumer credit and home mortgages, require that the issuer extend such funds in the ordinary course of business on the same terms available to the general public. See Exchange Act Section 13(k)(2).
16 See our article entitled "Be Prepared, the IPO Market Will Return" in the March 2002 issue of The Metropolitan Corporate Counsel.
M. Ridgway Barker is Co-Chair of the Securities Practice Group of Kelley Drye & Warren LLP. Randi-Jean G. Hedin is a Partner in the Securities Practice Group. Acknowledgement is given to Scott E. Kloin, an Associate of Kelley Drye & Warren LLP, for his efforts in the preparation of this article.