I. INTRODUCTION: FACTORS INFLUENCING THE SMALL BUSINESS’S DECISION TO GO PUBLIC
Prior to deciding to go public, the directors of a company, whether a corporation, limited partnership, or other entity, must weigh the advantages of going public against the disadvantages. After initial consideration of the traditional elements to be weighed in deciding whether to go public, this Essay explores the recently enacted Sarbanes-Oxley Act of 20021 and describes how the Act impacts this decision, with special focus on small and emerging companies. As will become readily apparent, the standard list of advantages and disadvantages must now include the Act as a crucial element for consideration.
In sum, the basic factors influencing a company’s decision to go public, aside from taxation and limited liability consequences, are as follows:
Access to capital: The public market affords companies unlimited funds that can be used for working capital, performing research and development, retiring indebtedness, entering new markets, or making acquisitions using stock instead of cash. After the initial public offering (IPO), subsequent financings are easier because the company has a track record with investors and securities regulators. In addition, public company shares are generally valued at a higher price than a comparative private company. This is because there are organized 102 THE JOURNAL OF SMALL & EMERGING BUSINESS LAW Vol. 6:3 markets through which the shares may be sold.
Liquidity: Prior to a company going public it is very difficult, if not impossible, for the shareholders to sell their shares. Liquidity also gives the principals of the company the ability to "cash out" their equity position in the company. Being able to provide shareholders with liquidity makes it much easier to entice investment. In addition, with the ability to sell, incentive stock options become more tempting.
Increased exposure in the marketplace: Being a publicly traded company can increase prestige in the marketplace and is thus itself a marketing tool for accentuating the positive and deemphasizing the negative. Increased exposure also affects the price of the stock, which can be either positive or negative.
Attract qualified personnel: A publicly traded company may be able to attract and retain more highly qualified personnel if it can offer stock options, bonuses, or other incentives with a known market value, especially in a tight labor market.
Expensive to obtain and maintain: Underwriting expenses, registration fees, public relations costs, legal and accounting expenses, and the costs of preparation of regulatory documents (including regular financial statements, annual reports to shareholders, financial reports, proxy material, and audited reports) must be considered.
Extraordinary time required: The process of going public requires a large commitment of management’s time and energy, drawing their focus away from the company’s core business. After carrying out the company’s IPO and listing its shares on an exchange, a portion of management’s time will be taken up dealing with regulatory requirements and generating market interest in the company.
Investor and public relations: This factor includes problems with unscrupulous investors manipulating the price of the stock, employees who become obsessed with the value of the stock on a day-to-day basis, hostile takeovers, special press relations, and so on. Securities regulations require that the board of directors review most matters that significantly and materially impact a company’s share value.
Loss of flexibility and control of company: It can be difficult to maintain flexible control of a publicly controlled company. In this regard, salary control is also often sacrificed. In addition, the price of the stock is subject to various swings that a private company would normally not experience.
Increased exposure to personal liability: One must consider the increased possibility of personal and class actions for questionable corporate action, which may involve causes of action for intentional torts such as fraud or RICO actions, which may expose one to personal liability. The Securities and Exchange Commission (SEC) considers management of a public company "insiders" who may have information significant to an investor. Accordingly, insiders cannot trade their shares until such information is available to the public.
Regulatory requirements and scrutiny: This factor includes unwanted disclosures to competition, interminable filing requirements, and the scrutiny of the SEC, the United States Justice and Treasury Departments, and other federal regulatory agencies. Antitrust and merger and acquisition regulation usually increases with the size of company.
II. THE SARBANES-OXLEY ACT AND ITS IMPACT ON THE DECISION TO GO PUBLIC
In response to an ongoing succession of the greatest corporate financial scandals in decades—in which giants of banking and industry have been exposed as common crooks, fraudsters, or both, cheating millions of shareholders and investors—the new Sarbanes-Oxley Act of 2002 has been enacted. This Act calls into serious question the issue of whether or not to go public. As this Essay will demonstrate, the Sarbanes-Oxley Act may tip the scales toward the decision not to take a corporation public, regardless of size and circumstance.
Critical aspects of the Act, which will likely discourage IPO formation, include:
1. Required certification by CEOs and CFOs of the periodic reports that must be filed with the SEC, attesting that they have disclosed the following items to the outside auditors and to the audit committee:2
- All significant deficiencies in the design or operation, or other material weaknesses of, internal controls;3 and
- Any fraud, whether or not material, involving management or employees with a significant role in the company’s internal controls.4
2. Substantially increased penalties for false certification of financial information: $1,000,000, up to ten years imprisonment, or both, if the violation was "knowing" or, if the violation was "willful," $5,000,000, up to twenty years imprisonment, or both;5
3. No public company may make, extend, modify, or renew any personal loan to its executive officers or directors, although existing company loans to officers and directors may continue unmodified.6 The few exceptions involve loans made in the ordinary course of the company’s business, on market terms, for home improvement and manufactured home loans, consumer credit, or extension of credit under an open-end credit plan or charge card.7
4. The filing of Form 4 (insider trading) is now due to the SEC within two business days after the execution date of the transaction, rather than before the tenth day of the month following the transaction—the deadline under current rules.8 The deadline can only be extended if the SEC determines the two-day period is not feasible.9 All filings must also be posted on the company’s web site.10
5. A public company is required to issue various additional disclosures:
- Off-balance sheet transactions, arrangements, and obligations (§ 401);11
- Adoption of a code of ethics for the CFO and principal accounting officer or controller, including notification of any later changes to this document (§ 406);12
- Each annual 10-K SEC filing must describe management’s responsibility to establish and maintain proper controls for financial reporting. Management must submit a report evaluating effectiveness of controls and procedures that must be attested to by the company’s CPA;13
- Pursuant to § 301 and effective no later than April 26, 2003, national security exchanges will be subject to newly drafted SEC rules requiring certain listing standards that will impose various requirements on the audit committee’s function and role within each publicly-traded company:14
- Audit committees must consist of independent directors, defined as those who receive no fees (other than normal director fees), own or control less than five percent of the voting securities issued, and are not a director, officer, partner, or employee of the company;15 and,
- Complaints from whistleblowers and other company critics that concern questionable accounting or auditing issues must be filed and stored by the company.16
6. Section 204 of the Act requires that registered public accounting firms report to the company’s audit committee. In their report, the accounting firm must set forth all critical accounting policies and practices being used, alternative treatments of financial information that have been discussed with management, ramifications of the use of such alternatives, and the treatment preferred by the accounting firm.17 Other material written communications between the accounting firm and management must also be disclosed to the committee.18 In addition, § 13 of the Securities and Exchange Act was amended by the Sarbanes-Oxley Act to require that financial statements reflect "all material correcting adjustments."19 This modification will require that companies improve their working relationship with their independent auditors.
7. Sections 201 and 202 prohibit registered public accounting firms from providing—"contemporaneously with the audit"—any professional services other than those provided in connection with an audit or a review of the financial statements of the company.20
8. A new lead partner and reviewing partner of the auditing firm are required at least once every five years.21
9. Several new crimes have been created for securities violations under § 802, effective immediately: failure of an auditor to maintain audit papers for five years; false information given the auditor; a twenty-five year maximum penalty for defrauding investors; and, a twenty year maximum penalty for destroying, altering or falsifying records with the intent to impede or influence any federal investigation or bankruptcy proceeding.22
10. In addition to providing whistleblower protection, Section 804 doubles the statute of limitations in civil actions for securities fraud from one to two years after discovery of the facts and up to five years from the actual date of occurrence thereof.23
11. Pursuant to § 307, attorneys practicing before the SEC are required to report evidence of material violations of securities laws or breach of fiduciary duty by a company to the general counsel or CEO, and if there be no appropriate response, to the company’s board of directors, audit committee, or independent directors.24
This newly imposed obligation is creating turmoil among corporations and their attorneys. The Act creates a new federal regulation of the practice of law. In so doing, the attorney-client relationship, with respect to the corporation, has been materially altered. Corporate counsel is now required to inform senior officers of corporate misdeeds. For example, if counsel becomes aware of misrepresentation in corporate financial statements to be filed with the SEC, this finding must be reported as far up the corporate ladder as necessary to insure remedial conduct. Thus, first the chief legal counsel or CEO is contacted. If unresponsive (whatever that should eventually be interpreted as meaning), the audit committee or full board of directors must be contacted.
One must assume that if the highest officers or directors do not respond, there may well be a duty to resign, leaving the issue as whether or not the shareholders (the ultimate owners of any corporation) must be informed in writing by the counsel in order to avoid charges of complicity and conflict of interest. In any event, this area is yet to be defined by the plethora of statutory and case law that will surely follow in the coming months and years. For example, by the spring of 2003, the SEC will be establishing minimum standards of professional conduct for any attorneys practicing before it. 25 However, at this time there is little guidance.
Of course, the entire Act and its consequences, in terms of time, public exposure, and expense, can be avoided by not coming within the definition of "issuer," which brings the company under the purview of the securities regulations. As defined in § 78c of the Securities and Exchange Act of 1934,26 almost any capital raising tool would qualify as a security. The real issue is whether the company is registered under § 12 of the Securities Act of 1933. Unless there are more than five hundred persons holding securities of record, whether the corporation is exempt from registration under §§ 12 and 15(d) of the 1933 Act becomes irrelevant unless the issuer is a foreign corporation, in which case registration is required. If one determines that alternative sources of start-up capital are desired, the issue then becomes feasibility.
III. THE INTERNATIONAL SCOPE OF THE SARBANES-OXLEY ACT
The negative impact on the U.S. economy has already been felt as foreign companies reconsider the listing of their stocks on American stock exchanges. Companies like Porsche, Daimler Chrysler, Bayer, and other nonexempt European firms are particularly upset with the Act’s requirement of executive affirmation of accounts.27 Porsche chief executive Wendelin Wiedeking commented on the Act, particularly that portion which seeks to safeguard against fraudulent accounting by requiring CEOs and CFOs to vouch for the accuracy of their company’s books under oath: That "makes no sense," Wiedeking said last month, with a company spokesman explaining that "hundreds of employees are involved in finalizing Porsche’s accounts and that under German law the management board is collectively responsible for them, not any individual."28
Various inconsistencies with similar European legislation are emerging, leading to issues of international conflict of laws. For example, in the U.K., shareholders have the sole responsibility for selecting auditors, whereas under the Act, this is the responsibility of a required audit committee. In the past, foreign private issuers have been exempt from the securities laws, and the SEC has exemption power therein.29 Written requests are already being contemplated or filed. In addition to London having raised objections, the German Industry Association announced that it would complain of inconsistencies with German law. In a letter to Fritz Bolkestein, European Union Internal Markets Commissioner, the German Justice Ministry said that U.S. laws could not be applied abroad and recommended that countries affected should seek their own arrangements.30 Only time will tell how foreign companies choose to navigate the regulatory maze of the Sarbanes-Oxley Act.
IV. OTHER OPTIONS FOR THE SMALL BUSINESS: REEXAMINING ALTERNATIVE SOURCES OF CAPITAL
Most small to medium sized business enterprises in America will agree that their principal objective is operational growth, fueled by access to cash and financing. Thus, alternative financing must exist for a company to avoid the tribulations of "going public." Alternative sources of start-up capital include private placement (including venture capital), personal investment, bank loans, government loans, or some combination thereof.
Because of the current interpretations of the new and existing regulations, banks and private investors may wish to avoid public scrutiny and exposure. Banks, as well as brokerage houses and venture capitalists, are increasingly held to a greater degree of scrutiny regarding the companies in which they are participating, financing, or promoting. Therefore, these institutional investors may now be more amenable to financing the private company, (given sufficient safeguards such as collateral and partial control, including possible membership on the company’s board of directors or executive committee), rather than sail through the unknown, choppy waters of the Sarbanes-Oxley Act.
As for existing companies seeking alternatives to raising capital by going public, a company may allow itself to be bought out by another, as many startups have sold out to Microsoft and other giants. This option offers speedier possibilities of raising capital. The shareholders benefit by the relative price stability offered by a larger corporation. A cash sale will also avoid stock restrictions and other regulatory headaches associated with the sale of shares in small and emerging companies.
One downside of selling out includes the generalization that an IPO could bring a significantly higher price for the purchased company’s shares and that the shares could accelerate in price much quicker than if stuck with a less volatile blue chip that is subject to weakness in nonrelated areas of its business.
V. THE BOTTOM LINE: HOW THE SARBANES-OXLEY ACT WILL IMPACT THE SMALL BUSINESS
Assuming you are a domestic small or emerging corporation who is now convinced that it would be premature or otherwise undesirable to proceed by public IPO, you may avoid the purview of the Sarbanes-Oxley Act by not maintaining more than five hundred shareholders of record, and by relying on private placement, personal investment, bank loans, or government loans or subsidies. Even a limited public placement should be avoided since there could be subsequent loss of the exempt status if, for example, the board of directors wished to raise additional capital by increasing the maximum number of shareholders beyond five hundred. Also, small businesses should avoid unsophisticated investors and public solicitation.
The Act’s impact is not just negative. Amid the Act’s adjustments, a more welcome climate in the lending industry may develop towards closely held corporations that can legally escape public scrutiny and complicated, costly regulations.
As for the overall impact on small and emerging businesses, of particular concern today is the probable domino effect upon small businesses and accounting firms. The Act may become the template for parallel federal and state legislative or rule changes that directly affect both nonpublic companies that are subject to other regulations and the CPAs that provide services to them. If the requirements come close to overlapping, the Act may end up making no difference.
The shock of the corporate scandals involving formerly highly respected and revered executives and auditing firms has led to reactionary legislation reminiscent of the populist movements during the trust-busting days of the two Roosevelt Presidencies. An activist Congress could fundamentally modify the role of the public corporation in society. The public corporation has now become more public, with the board of directors and officers charged with the same fidelity as though they were publicly elected officials and whistleblowers encouraged and protected.
The question of whether the Sarbanes-Oxley Act will become the mother of all corporate transparency bills is still premature. The Act is subject to legislative amendments and numerous court challenges and interpretations.
Public support and executive enforcement will lend needed corporate credibility. Whether the issue of corporate corruption becomes "politically charged" to the point of enactment of local legislation affecting small and emerging businesses will probably depend on the success of the federal regulatory efforts. By then emotions may have settled and the public pressure pushing the Sarbanes-Oxley Act forward will have faded. Only time will tell.
* Professor of Business Law, University of Southern Europe, Monaco; International School of Management (ISM), Paris; Hawaii Pacific University, Honolulu; Robert Kennedy College, Zurich, and International Business Lawyer. J.D. 1972, Loyola University School of Law. Professor Redner previously practiced general and business litigation in San Francisco, California, before moving to Europe in 1989, where he practices international business law. He has been a professor of international business law, lecturing undergraduate, MBA and DBA students and executives at European business schools such as Robert Kennedy College in Zurich, the International School of Management (ISM) in Paris, Hawaii Pacific University, and the University of Southern Europe in Monaco. He is currently presenting a self-designed course on post-Enron business ethics and liability.
1 Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, 116 Stat. 745 (2002).
2 Id. § 302(a).
3 Id. § 302(a)(5)(A).
4 Id. § 302(a)(5)(B).
5 Id. § 906(c)(1), (2).
6 Id. § 402(a).
8 Id. § 403(a).
11 Id. §§ 401(a), 13(j).
12 Id. § 406(a), (b).
13 Id. § 404(a)(1)-(2), (b).
14 Id. § 301.
17 Id. § 204.
19 Id. § 401(a).
20 Id. § 201(a).
21 Id. § 203(a).
22 Id. §§ 802(a); 1519; 1520.
23 Id. § 804(b)(1), (2).
24 Id. § 307(1), (2).
25 "This empowers the SEC, which in this capacity is acting as a prosecutorial body, to impose ethical standards on attorneys which may conflict with existing ethical codes of conduct," said Thomas A. Reed, a contract attorney acting as corporate counsel for BT North America Inc. in Manhattan and chairman of the Corporate Counsel Section of the New York State Bar Association. "I think that is a concern because the ethical rules are now enforced by the courts and disciplinary committees of the courts, which are well positioned to strike a balance between the public responsibilities of the attorney and the responsibilities of the attorney to the client." Corporate Reform Means Changes in Client Relations, N.Y. LAW. (July 29, 2002), athttp://nylawyer.com/news/02/07/072902c.html.
26 15 U.S.C. § 78c (2002).
27 Peter Gumbel, Tough Act To Follow: New U.S. legislation to combat corporate fraud provokes a backlash among European executives, TIME EUROPE, Sept. 23, 2002,http://www.time.com/time/europe/magazine/.
29 Kevin Drawbaugh, Europe pushes for exemptions to new U.S. acctg. rules, REUTERS, Aug. 19, 2002,http://www.reuters.com/news_article.jhtml?type=search&StoryID=1348361.
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