The Impact Of The Sarbanes-Oxley Act On Nonpublic Companies

For the most part, the sweeping Sarbanes-Oxley Act of 2002 (SOXA) applies only to "issuers," i.e., companies that must file periodic reports with the U.S. Securities and Exchange Commission (SEC). The changes intended by the new law are so broad and fundamental that it will be many years before they are all incorporated and fully appreciated. Over and above the intended changes, it is inevitable that some collateral, and perhaps unintended, effects and consequences will result as well. It is this broader, potential impact that should give rise to concern among those companies that are not issuers under the SOXA definition.

Primarily, the SOXA is an array of new regulatory powers the federal government can bring to bear on public companies and those who serve them. The SOXA includes some new and enhanced criminal provisions, as well as some authority under which private civil actions may be brought. Given that, why should private companies care about the SOXA?

Many of the issues addressed in the SOXA were on lists of "best practices" in corporate management. They are now minimum standards for public companies. Failing to comply is illegal. The bar has been raised considerably. Private companies must keep the minimum standards set in the SOXA in mind for a multitude of reasons. Many private companies want to become public companies. Others are building toward profitability in the hope of being acquired by other, perhaps public, companies. Private companies often seek credit from banks and other commercial lenders, and seek to raise equity through nonpublic offerings of securities. It is difficult to escape dealing with the regulators one way or another.

For example, a private company considering a public offering or being considered by another company for acquisition or merger will soon discover that it must have audited financials for three years from an independent auditor, independent directors, and a functioning, independent board audit committee. There can be no outstanding loans to directors (which can be a very sore point in clearing from the books on short notice). In the company governance structure, shareholder approval of certain executive compensation arrangements will be required. These features and more may necessitate a convulsion of change in company operations and culture if not incorporated into the central structure of the enterprise gradually, and long before going public is considered.

It also remains to be seen to what extent, if any, the minimum standards for public companies will seep into other areas. For instance, will commercial lenders begin to ask if potential borrowers have independent directors and auditors? Will bank regulators examining loan portfolios inquire of the bank if the borrower has an independent auditor and an independent board of directors? Will potential investors begin to give enhanced weight to the presence or absence of independent auditors and boards of directors? Clearly, the materiality of such factors has been heightened given recent scandals from a securities disclosure perspective, be it a private placement or a public offering prospectus. Is it possible that corporate governance and similar SOXA subjects will factor into determinations of the suitability of broker-dealer recommendations? Obviously, no one knows for sure, but the prospects of these and other such considerations reaching this level of importance are greater certainly today than in years past, and those who discount or ignore them altogether have simply not gotten the message.

As fascinating and puzzling as are the direct impacts and implications of the SOXA, it again is an array of federal authority, mandates, and remedies. Of far greater concern is the universe of private civil action. In enacting the SOXA, Congress was not the only revolutionary to toss tea into the corporate harbor. In tandem with the mood of the country that formed the underpinning of the SOXA and the accompanying regulations, significant and dramatic changes have taken place in the interpretation of Delaware corporate law, the body of law and the courts that serve as the standards for all state corporate law jurisprudence.

Whether the companies involved were publicly traded giants or smaller corporations was irrelevant to the recent decisions. These decisions applied to the board of directors, the individual independent directors, and the management of any (Delaware) corporation with shareholders.

The focus of these decisions has been the protections traditionally afforded to directors of a corporation under the business-judgment rule. Members of the board of directors of a corporation have been shielded from personal liability for errors or mistakes in judgment pertaining to law or fact, if they were able to demonstrate that they exercised prudent business judgment, i.e., if they discharged their duties in good faith and with that diligence, care, and skill that ordinarily prudent people would exercise in similar circumstances, in a manner they reasonably believed to be in the best interests of the corporation. In performing their duties, directors have been entitled to rely on information, opinions, reports, or statements, including financial statements and other financial data, if prepared or presented by corporate officers and employees, corporate lawyers, accountants, other experts, and other directors who serve on board committees on which they do not serve.

Generally, the business-judgment rule defense has not been available if the director is not independent or does not act in good faith or exercise due care. Absent evidence of fraud, bad faith, or self-dealing, the business-judgment rule usually applies to shield individual directors from personal liability. In making their business decision, they are presumed to act on an informed basis, in good faith, and in the honest belief they are acting in the best interests of the corporation (and the shareholders). The law does not require them to do the best job possible, just a reasonable job under the circumstances.

However, recent decisions and public statements by the Delaware judiciary have signaled a sea change in what is to be expected of independent directors generally, and more specifically the breadth of business-judgment rule protections. If the presumptive protection of the business judgment is defeated, under Delaware law the corporation is prohibited from indemnifying a director from liability for monetary damages as well. Colorado’s statutes are no more lenient than those in Delaware. In a recent case, the Delaware court went so far as opining that independent directors could be held personally liable for damages for their "deliberate indifference" to important matters. In doing so, they breached their duty of good faith.

At this point, it is problematic to attempt to predict "how high is up." In the wake of the many corporate scandals, courts have yet to opine in any decision that independent directors did enough to shield them from personal liability under the protection of the business-judgment rule. For any company that has independent shareholders or some other form of outside investor, the handwriting is on the wall: It’s not your money!

The mood and intent of Congress, the courts, regulators, and the public make it clear that corporate management and boards of directors are being held to the standards of a full fiduciary. They are charged with handling investor/shareholder funds almost as if they were deposits at a bank.

For private companies, there are core concepts in all of this that enlightened management should strongly consider embracing. Boards of directors should include a healthy proportion of independent directors selected by shareholders or other independent board members. Financial statements should be audited, and the auditor should be independent, i.e., perform no other services for the company. Corporate governance standards should be clear, incorporated into governing documents (articles of incorporation or bylaws), and not be subject to amendment without shareholder approval. Corporate loans to insiders (officers and directors) should be discouraged or prohibited altogether. If allowed, the rules governing them should be explicit and subject to board approval and oversight. Shareholder communication should be a major feature of corporate culture. In essence, what should be established is a system of checks and balances between the board and management, not unlike that between Congress and the executive branch.

All this will likely mean surrendering some authority and control by the owner-founder-president of a private company to independent people. That can be a scary thought for anyone in that position. To avoid the problem, the answer, although impractical in most circumstances, is simple: Don't seek and take investment capital from those outside the company. If you have outside investors, this is a brave new world, with heightened expectations and demands on us all.

At Rothgerber Johnson & Lyons LLP, our attorneys are poised to assist in navigating these new and treacherous waters. These are not things that are just happening to the "other guys." They affect all of us.