Why Private Companies Should Be Mindful of Sarbanes-Oxley

By John W. Pauciulo

In 2002, Congress passed the Sar - banes-Oxley Act in response to cor - porate scandals such as Enron and WorldCom. The Act primarily applies to public companies but it also has significant implications for private companies as well. Parts of the Act can affect privately-held companies even though those businesses may have no legal obligation to comply with the rest of it.

Corporate Governance

The Act has raised the bar for what constitutes best practices in corporate governance. The Act contains many provisions which are intended to lessen the chances of fraud, self-dealing and mismanagement. For example, under the Act, a majority of the members of public companies boards must be independent. The term independent is defined as someone who is not an employee of the company, not an owner of more than a specified percentage of the companys shares and not recently employed by the companys auditors. Directors who are independent are more objective, more likely to ask tough questions of management and better able to protect the interests of all shareholders.

Because of the Sarbanes-Oxley standards for public companies, lenders, venture capital companies and insurers are scrutinizing the corporate governance practices of those with whom they do business public and private firms alike. Companies complying with key provisions of the Act related to corporate governance will be perceived as operating at the highest and best level and are more likely to succeed with lenders and investors.

Entrepreneurs who form privatelyheld companies often have a plan for how they will divest their ownership in the company (or some portion of it) and reap the rewards of their companys growth. Common exit strategies include an IPO or a sale of the company to a third party. Entrepreneurs who expect these types of transactions to be the means by which they recoup their investment, should consider the Acts requirements from the beginning of the venture.

In order to complete an IPO, in addition to the already difficult process of going-public, private companies must comply with the Act. That means a private company working towards IPO may have to amend its by-laws so as to identify and retain independent directors. If not anticipated earlier, this process could be time consuming and distracting at a moment the company can least afford. The reconstitution of a board will be further complicated if board seats are held by venture firms with contractual rights to them. Ultimately, some director constituencies will need to share power with independent directors. Underwriters will expect that private companies have considered the Act and complied with it well in advance of seeking to go public. Private companies for which an IPO is even a remote possibility should evaluate its organization against the requirements of the Act and develop a compliance program.

As to the private sale, compliance with the Act will make a company more attractive (i.e., valuable) to a public company for several reasons. One example stems from the requirement under the Act that the CEO and CFO of a public company personally certify that they have evaluated the controls and procedure in their companies during the last quarter and concluded that such procedures are in place and effective. After an acquisition, the financial statements of the target will be integrated into those of the acquirer. Consider the problem presented for the CEO and CFO of a public company who must personally certify financial statements derived, in part, from the numbers of a private company which were not prepared in compliance with the Act. The private company which has complied with the Act will be more attractive to a public company and those that do not comply with the Act may face acquirers who negotiate down the price to factor in the additional risk.

Reduce Litigation Exposure

The fiduciary duties of officers and directors in all companies, public and private, are the same. To the extent that the Act has raised the bar for directors and officers conduct in dealing with auditors, preparing and reviewing financial statements, insider transactions and loans, these higher standards may well affect the traditional duties of care and loyalty and, in turn, the potential liabilities of directors and officers. Companies which have implemented provisions of the Act such as those related to independent boards, audit committees, and the prohibition of loans to officers will, in all likelihood, limit potential claims.

Best Practices

While many aspects of the Sarbanes- Oxley Act may not expressly apply to private companies, there are some good reasons to undertake a Sarbanes-Oxley audit. Such companies should consider which aspects of the Act may be appropriate for immediate adoption so as to remain competitive, limit risk, and be prepared for a liquidation event.

Here are some best practices to consider: identify one or more truly independent persons to serve on the board; establish board committees to manage the companys relationship with its accountants; confirm that the outside accountants are well suited to the companys needs and are independent of management; prohibit or carefully limit transactions between the company and its directors and officers; and review the companys process for financial reporting and internal controls. Even for small, privately held companies, such practices may prove very helpful and save time in the future.

John Pauciulo practices in the Business Department in Philadelphia and he can be reached at 215-864-7146 or pauciuloj@whiteandwilliams.com.