December 2007
The adoption of the Sarbanes-Oxley Act in 2002 dramatically changed the regulatory framework for public companies. The Act aimed to protect investors by improving the accuracy and reliability of public disclosures. While compliance with the Act has proven to be costly, it has resulted in improved corporate governance practices and more reliable financial disclosures.
Privately-held companies may benefit from adopting some of the best practices developed for complying with the Act. Voluntary adoption of certain provisions of the Act can make a company a more attractive candidate for an acquisition, public offering, or equity investment. The standards established by the Act are often considered by potential acquirors, venture capital investors, lenders and others during their due diligence investigations. Also, selective compliance by privately-held companies may bring other benefits, such as improved communication within the organization. Many companies may find their own Boards of Directors advocating for such changes.
The following set of resolutions aims to improve corporate governance and financial controls for privately-held companies and should be considered in the coming year based on best practices developed under the Act. Private companies and their Boards have the benefit of being able to pick and choose their areas of concentration and priorities depending on goals for the coming year.
Adopt a whistleblower policy. The Act requires all companies to adopt a policy allowing employees to file complaints regarding internal problems or concerns without risking retaliation by their employer. As part of such a policy, companies should develop a mechanism to allow employees to file these complaints on an anonymous basis. A whistleblower policy may also benefit employers by encouraging employees to inform management of issues and concerns that, without such policy, may have gone undetected.
Prohibit Loans to Executive Officers. The Act prohibits all loans from a public company to an executive officer. Private companies should consider a similar prohibition on future loans to executives. Because this prohibition is in place immediately upon an IPO or acquisition by a public company, companies may also consider resolving any outstanding loans to executive officers.
Require Board Approval of Related Party Transactions. Boards of Directors should consider adopting policies requiring that all transactions between the company and an executive officer, director, or significant stockholder be pre-approved the Board. This extra step will provide the Board with notice of potential conflicts of interest.
Adopt a Code of Ethics. Companies may consider preparing and adopting a basic code of ethics designed to promote honest and ethical conduct, compliance with laws and internal reporting of violations of the code. In order to avoid unintentional violations the executive team must review the code against the company's current practices and educate all employees as to the code's requirements and prohibitions.
Increase the Number of Independent Directors. While it is often difficult for private companies to attract outside directors, companies should consider increasing the number of independent directors on their Boards over time with a goal of having a majority of independent members. This long-term goal often becomes more relevant as a company grows.
Appoint an Audit Committee. Though not required, the Board of Directors may consider appointing an Audit Committee of the Board. The members of the Audit Committee should be independent directors and at least one should have financial expertise. The Committee would be responsible for selecting the company's accounting firm, reviewing the financial results with the auditors and working with management to develop and improve financial controls and policies.
Limit Outside Audit Firm's Work to the Audit. Once a private company hires an outside audit firm to perform an annual audit, it should limit that firm's involvement with the company to audit-related activities. This limitation protects the independence of the audit firm. Companies may hire a second accounting firm to prepare tax returns and perform other accounting functions not related to the audit.
Begin to Consider Internal Controls over Financial Reporting.Companies considering a public financing or acquisition by a public company should begin to evaluate their internal controls over financial reporting and identify weaknesses in these controls. Specifically, companies may begin to identify and remedy areas that could cause material misstatements in financial reports to go undetected. While most private companies lack the resources and financial staff to undergo a complete analysis, in order to provide acquirors with comfort regarding a target's financial statements target companies should focus on establishing good financial controls for their size. The SEC has released guidance for small public companies on how to structure and evaluate a system of internal controls. Private companies may find this guidance helpful as they structure their own programs.
For more information on corporate governance, please contact the author Daniele Ouellette Levy.
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