The Sarbanes Oxley Act of 2002 (“SOX”) federalized significant portions of the corporate law for companies that are publicly traded. Now privately held companies are feeling the impact of SOX.

Corporation law has historically been essentially a state law matter. Corporations are created under state law. The duties of corporate directors and officers, although they are generally similar across all states, can vary in legal specifics depending upon the state in which the corporation is formed.

Under the securities laws, some corporate obligations have been governed by federal law for decades.  Examples would be the form and content of proxy statements sent to shareholders in connection with annual meetings, or the requirement that officers and directors report their purchases and sales of their own company's securities. Prior to SOX, most of the operational elements of the corporation continued to be governed by state law.

SOX, and the related rulemaking by the Securities and Exchange Commission, required (among other things) that company audit committees have significant new authority regarding the hiring of company auditors and the conduct of audits. SOX also required that companies ensure the independence of at least a portion of the board of directors from corporate management and that companies adopt a code of ethics.

SOX required that the lawyers for companies report suspected fraud or securities violations “up the ladder” to the board of directors if management did not take action and that whistleblowers who notified corporate management of suspected financial improprieties be protected from retaliation. Finally, SOX also mandated that the CEO and CFO certify the accuracy of the financial information presented to investors.

Through these statutory and regulatory requirements, new federal standards have replaced the various state standards governing these matters, at least insofar as public companies covered by SOX are concerned.  Increasingly, private companies are seeing the need to make their methods of operating move closer to those required by Sarbanes, particularly on accounting or governance matters.

For example, if the investors in a privately held company would like a public company to acquire it, they need to be mindful that the buyer will be certifying the accuracy of the financial statements following the takeover. This means that the buyer will not only have to be satisfied with the accuracy of financial statements prepared by the private company before the acquisition, but will have to be assured that the financial controls are in place to make other necessary SOX certifications.

For a private company, having extensive SOX-quality financial controls and squeaky clean financial statements may or may not be important from an operating standpoint.   Extensive controls in a small company, for example, might be expensive and time-consuming to set up and maintain, compared to any immediate benefit that the company received.

Private companies that are considered acquisition by public buyers, however, need to be attuned to the SOX financial statement requirements so that they can be attractive acquisition candidates. If they don't, the public company buyers might place a lower value on the business, or take longer to complete an acquisition in order to ensure that all necessary elements are in place before a deal is done.

Likewise, the independence of directors from management has the potential to develop into an “industry standard” or “best practice” for corporate boards, and perhaps even affect the legal standards for director duties to shareholders. The chief judge of the Delaware Chancery Court, which is the state court in Delaware that deals with key corporate issues for leading U.S. corporations, indicated recently that the standards set by SOX for director conduct would be used in considering whether, as a matter of state law, directors had breached their fiduciary duties to shareholders.

For some privately held companies, the founder is accustomed to treating the company more like a sole proprietorship .  If the founder is in fact the sole shareholder, there are no shareholders to complain. Though there is always a risk that if corporate formalities are not respected, creditors could “pierce the corporate veil.”

For private companies with significant numbers of outside investors, the focus on independence of directors is a way of ensuring that the shareholders' rights are protected. That is not a legal requirement for private companies, but private company owners and managers should be aware of the direction in these corporate governance trends.

 

Bruce Dravis is a partner at Downey Brand LLP, operating primarily in the firm's Sacramento and Roseville offices, specializing in corporate, securities and business law.