Public companies are facing dramatic changes in disclosure and corporate governance requirements under the Sarbanes-Oxley Act of 2002 and new or proposed rules from the SEC, NASDAQ and the NYSE. While these new rules and regulations do not generally cover private companies, they do affect private companies:
Summarized below are the new requirements that are most likely to be relevant to private companies. Familiarity with these new rules will help private companies avoid pitfalls that could interfere with important future milestones, such as an IPO or acquisition, and help establish a culture of fiscal and corporate responsibility.
Prohibition on Personal Loans
The Sarbanes-Oxley Act prohibits public companies and companies that have filed an IPO registration statement (even if not yet effective) from extending, maintaining, renewing or arranging personal loans to directors or executive officers. Loans that existed on July 29, 2002 are permitted to remain outstanding, so long as they are not materially modified or amended. Upon the filing of an IPO registration statement, all outstanding loans made after July 29, 2002 to a person who is a director or executive officer of the company at the time of filing will be illegal.
Private companies should consider prohibiting all officer and director loans or requiring that any loans made or modified after July 29, 2002 be repaid immediately prior to the filing of an IPO registration statement if at that time the borrower is a director or executive officer of the company. Private companies should also consider requiring repayment if the company is acquired by a public company and the borrower becomes a director or executive officer of the acquirer.
However, private companies should bear in mind that repayment prior to the filing of an IPO registration statement, or an acquisition, may not be practical since there will not yet be a public market for the company's stock, and forgiveness of such loans may result in unfavorable accounting treatment.
Stockholder Approval for Stock Plans
The NYSE has proposed changing its rules so that brokers holding stock of a public company in "street name" may vote those shares in favor of proposals to adopt a new employee stock plan or to increase the number of shares covered by an existing plan only if explicit voting instructions are received from the underlying beneficial owner. This change would affect all public companies, since it would apply to voting by all brokers that are members of the NYSE, regardless of where the shares being voted are listed.
This rule change may make it significantly more difficult for public companies to obtain stockholder approval of stock plans. This underscores the need for a company contemplating an IPO to evaluate whether it needs to increase the number of shares covered by its employee stock option plan and whether it wishes to adopt any new stock plans-such as a director stock option plan or an employee stock purchase plan-while it is still a private company and stockholder approval is easier to obtain.
Board of Directors and Board Committees
Private companies should be prepared to comply with the new rules relating to the composition of a board of directors and board committees prior to filing an IPO registration statement:
Relationship with Auditors
The Sarbanes-Oxley Act will affect a private company's relationship with its accountants:
Disclosure Controls and Internal Controls
Public companies are now required to maintain, and periodically evaluate and report on the effectiveness of, "disclosure controls and procedures"-that is, controls and other procedures designed to ensure that information required to be disclosed by the company in its SEC reports is assimilated and processed within the required time periods. The SEC has proposed similar rules regarding "internal controls and procedures for financial reporting"-that is, controls regarding the preparation of financial statements for external purposes that are fairly presented in conformity with GAAP.
Any private company planning to go public should establish appropriate controls and procedures so that it will not need to substantially re-engineer its business processes following an IPO. The IPO underwriters will scrutinize the company's controls and procedures as part of their due diligence process. Similarly, any potential public company acquirer will conduct significant due diligence on the private company's controls and procedures so that the acquirer is in a position to provide all required SEC certifications following the acquisition.
As investors and financial institutions change their standard forms and operating procedures in response to the new regulatory environment, some of their new practices and the covenants, representations and warranties that they will require of public companies will inevitably begin to impact private companies. For example, investors in private companies may begin to require audit committees to comply with the membership rules applicable to public companies.
Patrick Roundeau's practice concentrates on public offerings, mergers and acquisitions, venture capital work and general corporate and securities work. He is a 1981 summa cum laude graduate of Williams College and a 1984 cum laude graduate of Harvard Law School. He joined Hale and Dorr in 1984 and has been a senior partner since 1992. Mr. Rondeau is the former co-chair of the Securities Law Committee of the Boston Bar Association, and frequently speaks at seminars on securities law and related topics.
David Westenberg represents technology companies in their formation and initial funding, venture capital investments, merger and acquisition transactions and public offerings. Mr. Westenberg is active in various technology councils and has represented the Massachusetts Telecommunications Council since its formation. He also chairs Hale and Dorr's Internet and E-Commerce Group and co-founded its Telecom and Wireless Group. Mr. Westenberg received a J.D. degree from Harvard Law School and an S.B. degree from the Massachusetts Institute of Technology. He serves as Co-Chair of the Corporate Law Committee of the Boston Bar Association.