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The
duties and obligations of officers and directors of large,
privately held companies will be significantly affected
by recent corporate governance reforms. While these reforms
generally apply to companies with publicly traded securities,
the changing norms of corporate conduct soon will affect
all companies with a significant number of non-management
shareholders.
These
large, private companies will face a number of risks that
make it important for them to consider changes in corporate
governance to meet the needs and requirements of lenders,
accountants, insurers, government contracting agencies and
shareholders. The most important of these risks involve
determination of earnings (as they may affect management
compensation and the price and amount of stock bought, sold,
awarded or put under option) and the obligation of attorneys
to report material evidence of misconduct. Thus, management's
and the attorney's duty of loyalty to the corporation as
an entity and not to its constituent parts is being emphasized.
Additional
risks, absent internal changes, may include difficulties
in:
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Borrowing money.
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Maintaining director and officer insurance.
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Qualifying for and maintaining government contracts.
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Meeting ERISA obligations.
Recommendations
Private
companies now should begin to review and make changes in
their corporate governance structure and practices, their
system of internal controls, their approach to financial
reporting and their corporate culture regarding appropriate
behavior. Recommendations for change include:
-
Large, privately held companies should create an audit
committee on which independent directors serve. An
important part of recent Sarbanes-Oxley legislation and
New York Stock Exchange proposals is insistence on objective
oversight -- in the form of an independent audit committee.
Convening an independent audit committee will protect
the board and senior management and will provide further
assurance to creditors, regulators, insurance companies
and independent auditors. In the future, it is likely
that lenders, accounting firms and government agencies
will expect and demand that privately held companies convene
audit committees. So, there may be future liability risks
in not doing so.
-
Large, privately held companies should conduct periodic
reviews of the adequacy and scope of their internal controls,
implementation of those controls, operation of internal
audit systems and follow-up on internal audit recommendations.
Sarbanes-Oxley requires that management certify that a
company has in place a system of internal controls adequate
to gather the information that management needs to evaluate
and reflect in financial statements a fair representation
of the condition of the business. While this certification
may not be legally required for privately held companies,
a sound system of internal controls is necessary to minimize
risks. Lenders, bonding companies, insurance companies
and other parties can be expected to use the new public
company best practices based on Sarbanes-Oxley.
-
Large, privately held companies should consider accompanying
their financial statements with a "Management's Discussion
and Analysis" section as found in public company
reporting. Over the last year, "Management's
Discussion and Analysis" of the financial statements
of publicly traded companies has become a critical adjunct
to financial statements -- reflecting management's assessment
of the company's performance, of known or likely trends
in the business, and of the effects of critical accounting
policies and estimates. Such discussions go beyond the
requirements of GAAP and facilitate a transparent presentation
that is fair and not misleading. The enhanced disclosure
comports with the clear trend of public policy and may
soon be expected or required by lenders, insurers, the
government, business partners and others. While inclusion
of a management discussion entails meeting a new set of
standards, a company's aggregate exposure may very well
be less with a discussion than without it. Private companies
should consider accompanying their financial statements
with this type of a discussion.
-
Large, privately held companies should undertake to
have their directors, officers and employees become familiar
with Sarbanes-Oxley requirements pertaining to lawyer
reporting of misconduct (and the reasons behind them)
and to modify their internal procedures to accommodate
these new standards. Sarbanes-Oxley requires lawyers
with material evidence of misconduct to report it to the
general counsel, CEO or board of directors. The American
Bar Association also has recommended changes in attorney
ethics rules to require this action. Unlike Sarbanes-Oxley,
which by its terms applies to issuers of publicly traded
securities, the canons of legal ethics (for which the
model rules serve as a guide) apply to all lawyers, including
those serving private companies.
-
Large, privately held companies should review the operations
of their employee benefit plans to confirm compliance
with the ERISA reporting and disclosure requirements and
compliance with ERISA fiduciary duties. Sarbanes-Oxley
includes provisions affecting ERISA plans maintained by
private companies as well as public companies. It significantly
increased the criminal penalties for violation of ERISA
reporting and disclosure requirements and created strict
new rules regarding blackout periods for any retirement
plan allowing self-directed investments. The audit committee
and whistleblower provisions of Sarbanes-Oxley suggest
new approaches for addressing fiduciary issues relating
to ERISA plans, particularly those plans investing in
employer stock.
-
Large, privately held companies should consider the
impact of Sarbanes-Oxley when directly or indirectly lending
money to executive officers and directors. Section
402 of the Act, prohibiting loans to executive officers
and directors, does not apply to private companies before
they go public. Nevertheless, to protect against the possibility
that a company could violate §402 at the moment it
goes public, loans and credit arrangements for the benefit
of executive officers and directors must be structured
so that they can be terminated before an IPO without significant
adverse consequences to the company.
Summary
Large,
privately held companies should:
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Understand both the spirit and rationale behind the new
corporate governance regime for publicly traded companies.
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Realize it is very likely that similar standards of behavior
-- and possibly penalties -- shortly will apply to privately
held companies.
-
Adapt their corporate governance structures and practices
accordingly.
State
corporate law and principles of fiduciary duty do not distinguish
between publicly held and privately owned companies. As
state corporate laws begin to reflect the important changes
in expectations for company boards and managements, including
changes that inevitably will affect application of the business
judgment rule, privately-held companies would be wise to
adjust their corporate governance policies and procedures.
While
every private issuer need not meet all of the requirements
being laid down for public companies, every privately-held
company should examine its practices in light of the new
regulatory regime and adjust its policies and practices
sooner rather than later.
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