Infotech and the Law: Public rules are good for private companies

Jonathan Cain

In the regulatory fallout from Enron, WorldCom and other business scandals, owners and officers of privately held IT companies may find reason to be thankful they missed the booming initial public offering market.

At least they avoided most of the legal obligations imposed on publicly traded companies as a result of those scandals.

Those same people may be wondering whether the time now is right to consider taking their companies public.

What they may not have considered is that future investors will be looking to see if these private companies adopted many of the changes in corporate regulation imposed on public companies.

A few provisions of the Sarbanes-Oxley Act apply to both privately held and public companies. These include penalties for destroying documents to impede a federal investigation and increased penalties for mail and wire fraud.

More important, however, is the developing body of academic research into the performance of privately held companies since Sarbanes-Oxley became law. The research shows private companies that adopt corporate governance practices required of public companies have produced better returns for investors and higher valuations at acquisition. This lesson is not lost on sophisticated investors.

There are many reasons why investors are looking for corporate governance reforms in private companies.

It helps smooth the transition from pre-IPO to public company status if listing requirements of the stock exchanges are already being followed. Evidence that an acquisition target has been following corporate governance guidelines reduces risk to the buyer, which may be reflected in the acquisition price.

It reduces the cost of director and officer liability insurance, and it expands the pool of outside talent willing to serve as independent directors of the company.

Private companies planning an IPO should first consider its board of directors. Both major stock exchanges have adopted rules that require a majority of board members be independent. Under Nasdaq, that means that the director has not been employed by the company or taken more than $60,000 in other compensation from the company for the past three years.

With suitable outside directors engaged, it is relatively easy to form an audit committee of outside directors and adopt a committee charter. Other required committees can be formed after the IPO.

Another step vital for government contractors and important for all privately held companies is adoption of an employee code of conduct and ethics.

Government contractors should pay special attention to procurement integrity issues in the code, but every company should have a code that sets out expectations of honest, ethical conduct by officers and employees and provides a reporting process for whistleblowers.

This plan is vital to defending the company in the event of contract suspension or debarment and can protect uninvolved officers and directors from more serious consequences, such as criminal prosecution. A good compliance plan, and the accompanying employee training, is some of the least expensive insurance a government contractor, public or private, can buy.

Finally, new company loans to insiders should be avoided.

Private companies that made loans to insiders before July 2002 can grandfather those loans if they go public, but later loans violate the restrictions placed on public companies and cannot be grandfathered. Private companies should find other ways to compensate insiders.

Each of these steps is necessary if a private company is planning an IPO, and they may be just as valuable even if a company seeks investment from a small group of investors in a private financing or to position itself for acquisition.

Jonathan Cain is a member of the law firm Mintz Levin Cohn Ferris Glovsky & Popeo PC in Reston, Va. The opinions expressed in this article are his. He can be reached by e-mail at jcain@mintz.com.

About the Author

Jonathan Cain is a member of law firm Mintz Levin.

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