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BEST PRACTICES FOR PRIVATE COMPANIES IN AN ERA
OF
CORPORATE REFORM
By Marcus
J. Williams
[December 2002]
The Securities and Exchange Commission, as well as a host of law
and accounting firms - and even securities issuers - are writing
new dictionaries of corporate-speak in an effort to restore their
collective legitimacy following the markets' recent abysmal performance.
One particularly noteworthy response is the recently adopted Sarbanes-Oxley
Act, a congressional mandate that imposes rigorous new corporate
governance standards on public companies. The Act is the most significant
of a spate of recent regulatory activity, beginning in December
2001 with several SEC recommendations, and several bulletins describing
these regulations can be retrieved at http://www.dwt.com/practc/corp_fin/corp_fin.cfm.
Executives of privately held companies may tend to dismiss these
new measures, believing they apply exclusively to public companies.1
However, private company executives should view the changes as providing
a valuable opportunity to adopt a set of "best practices"
that will improve shareholder relations and allow their companies
to tout their own "corporate integrity." These steps will
likely translate into significant value for the privately held company
by increasing the company's intrinsic value. Perhaps more importantly,
these practices may increase the company's actual value by presenting
to a prospective buyer a clear picture of a well-managed enterprise
whose financial statements and records are reliable and whose executive
management and board of directors are appropriately focused on corporate
responsibility. The end result: higher values realized in a sale
of the company, and enhanced credibility with underwriters if the
company decides to "go public."
Moreover, the alternative to taking proactive measures can sometimes
be disaster. One could hardly have ignored the public uproar over
the accounting and corporate fraud scandals at Enron, WorldCom,
Global Crossing, Tyco and a host of smaller companies, but a noteworthy
thread connects each of these scandals and nearly every other instance
of corporate fraud and malfeasance: shareholders - whether public
or private - entrust corporate executives with their investments
and rely on those officers both to operate their enterprises with
diligence and integrity, and to tell the unvarnished truth about
the company's financial condition, operating results, problems and
planned solutions. When executives breach that trust, two common
themes will consistently emerge.
First, misconduct nearly always will go undetected for long periods
of time because outside shareholders lack the direct ability to
supervise the company's day to day operations. Shareholders trust
management in part because they believe their board of directors
will select officers of competence and integrity, and in part because
they have no other choice.
Second, when breaches of trust ultimately are discovered, the shareholders
justifiably will blame not only the dishonest executives, but also
their board of directors. After all, the corporate model is built
on a republican (small "r") model: because shareholders
cannot supervise management directly, they entrust that function
to the directors they elect. While directors rightly entrust to
management extensive responsibility for operational and financial
performance, that trust cannot be blind. Directors must, therefore,
maintain a careful balance, permitting executives to operate the
enterprise while curbing the kinds of abuses that, although vividly
illustrated by recent public scandals, are all too common in large
and small companies whether public or private.
With this backdrop in mind, what lessons should private companies
take from the Sarbanes-Oxley legislation and from the new regulations
being adopted by the SEC and the securities markets? A number of
these initiatives may be helpful to shareholders, directors and
executives considering ways to improve corporate responsibility
and prevent or mitigate instances of management misconduct:
- Director Involvement and Responsibility.
Directors must assume their proper role and must supervise - and,
from time to time, direct - management. Many recent public scandals,
and perhaps just as many private ones, could have been averted
or minimized by a board of directors that pressed management for
details, reviewed financial and operational data, and verified
management's assertions. While some might have viewed this degree
of involvement as meddling or reflecting mistrust, that is
exactly the obligation our corporate system places on directors.
Equally significant is the fact that honest, competent executives
recognize this corporate governance principle, and should thus
welcome the involvement and oversight.
- Director Independence. Both the
Nasdaq and the New York Stock Exchange have proposed rules that
would require listed companies to maintain a board consisting
of a majority of independent directors, and it seems clear that
directors whose connections to management are limited are much
more likely to ask difficult questions and less likely to trust
management blindly. Clearly this principle applies equally to
private companies, although the practical ability to address this
concern - as well as the meaning of "independent" -
will vary in light of each company's specific circumstances. Even
if only a minority of directors can be independent, however, the
presence and active involvement of those directors will likely
serve as a meaningful check on management.
- Financial and Business Sophistication.
Along with the need to retain directors who are willing to ask
probing questions, a board should consist of directors who have
the financial and business expertise to know when to ask those
questions and to understand the answers. As with independence,
this issue is best addressed in the private company setting by
considering the attendant circumstances, but independence and
best intentions are highly undermined unless they are accompanied
by competence.
The occasional displacement of integrity and dedication by greed
and egotism means, unfortunately, that the most recent wave of scandals
will not be the last. Nonetheless, the current reforms offer a number
of lessons by which public and private companies can improve their
governance and management and, hopefully, their operational and
financial performance.
FOOTNOTES:
1Other
than the antifraud provisions (see, e.g., Sections 308 (Fair
Funds for Investors), 802 (Falsification and Destruction of Corporate
Records), 803 (Limitations on dischargeability of Certain Debts)
and 902 (Conspiracy and Criminal Fraud)) and the extension of the
statute of limitations (See Section 804), private companies can
largely ignore the statute and the surrounding melee.
Any questions about this article should be directed
to:
Marcus Williams,
Portland, (503) 778-5370, marcuswilliams@dwt.com
This Corporate Finance article is a publication
of the Corporate Finance Group of Davis Wright Tremaine LLP. Our
purpose in publishing this article is to inform our clients and
friends of developments in corporate finance. It is not intended,
nor should it be used, as a substitute for specific legal advice
as legal counsel may only be given in response to inquiries regarding
particular situations.
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