"Going Private" After The Sarbanes-Oxley Act of 2002
The Sarbanes-Oxley Act of 2002 (the "Act"), enacted in the wake of the recent corporate scandals, imposes unique and perhaps unintended burdens on the small public company. The Act's increased level of regulation will cause smaller public companies without the compliance infrastructure of a large company to incur increased administrative, legal and accounting fees to keep up with the new rules. When compounded with the current downturn in the public capital markets, the burdens of complying with the requirements of the Act should make certain smaller public companies consider whether "going private" makes sense.
What follows is a brief summary of the requirements of the Act that can significantly impact small public companies. Also included are other reasons why small public companies should consider going private. Finally, included in this advisory is a short guide to "going private".
Requirements of the Act and Their Impact on the Small Public Company
Certification of Financial Statements: Sections and 302 and 609 of the Act require the CEO and CFO of a public company to certify that a company's periodic reports are not misleading within the meaning of Rule 10-b5 of the Securities and Exchange Act (the "Exchange Act") and that the financial information included in the periodic reports "fairly present" in all material respects the financial condition of the company. In addition, Section 302 requires that the CEO and CFO further certify that "disclosure controls and procedures" and internal accounting controls are in place to ensure the accuracy and timeliness of the information included in the periodic reports. An officer who signs this certification knowing a report is not in compliance may be fined up to $1 million and imprisoned up to 10 years. A officer who "willfully" violates the certification requirements may be fined up to $5 million and imprisoned up to 20 years.
Since executives will be personally liable for the accounting practices of their company, it is likely that the cost of directors and officers ("D&O") insurance is likely to increase substantially. According to one report, financially strong companies can expect an increase of 25-40% in D&O premiums and weaker companies can expect increases of up to 400% . In addition, these requirements increase the cost of independent audits of a company's financial records. The Wall Street Journal has reported that accounting costs are likely to increase 15 to 25 percent over the next year.
No Loans to Directors and Officers: Section 402 of the Act prohibits public companies from extending any new credit to a director or executive officer or from renewing or extending existing loans. In addition, this Section may operate to eliminate the common practice of allowing officers and directors to exercise stock options through a "cashless exercise". In a cashless exercise of options, a company-selected broker pays the exercise price on behalf of the option holder, either with a short-term loan made against the option shares being acquired or with the proceeds of the sale of the option shares acquired.
At present, it is unclear is Section 402 will operate to prohibit cashless exercises. However, given the potential civil and criminal penalties for a violation of the Act, a prudent course would be to refrain from cashless exercises.
Independent Boards and Audit Committees: Section 301 of the Act requires a company's audit committee to be comprised entirely of independent, unaffiliated directors who may not accept any compensation from the company other than compensation for being on the committee. SEC rules implementing Section 407 of the Act require companies to disclose whether at least one member of the audit committee is a "financial expert." In addition, a majority of the board members must be independent.
Faced with the new requirements for board members and audit committees, small public companies are engaging executive search firms to find new directors and financial experts for their boards and audit committees . Many smaller companies will find it difficult to recruit such experts, given the risks now associated with serving on an audit committee or as a director.
Accelerated Company Disclosures: Section 403(a) of the Act requires officers, directors and principal security holders to report changes of beneficial ownership in reports required to be filed under Section 16(a) of the Exchange Act. Under the old Section 16(a), most such transactions were to be reported monthly within 10 days after the close of each calendar month in which the change occurred. Under the new SEC rule implementing Section 403(a), reports must generally be filed "before the end of the second business day following the day on which the subject transaction has been executed." The SEC has also shortened substantially the deadlines for filing periodic reports on Forms 10-K, 10-Q and 8-K.
For larger companies with internal compliance departments, these changes may not work a financial hardship. However, a small public company will be spending significant money on outside attorneys and accountants to comply with accelerated filing and disclosure requirements.
Other Reasons Small Public Companies Should Consider Going Private
Compounded with the burdens of complying with the Act is the recent downturn in the public capital markets. Traditionally, a primary reason for a company to go public was to gain access to investment capital in the public capital markets. The public capital markets are at present effectively closed for most small companies, so one of the main benefits of being a public company is now virtually erased.
In addition, three years of down markets have driven down the market capitalization of many companies well below fair market value. In the current climate, insiders cannot sell any substantial portion of their holdings without driving the stock price even lower.
Recently enacted Regulation FD (Fair Disclosure) also places difficult and confusing limits on public disclosures by company officers and directors. Regulation FD was enacted to prevent public companies from disclosing important, nonpublic information about the company or its securities only to market professionals and certain shareholders. Regulation FD does this by requiring that if companies disclose "material" nonpublic information to insiders, they must also disclose the same information simultaneously to the general public, usually by filing a Form 8-K.
Regulation FD does not specify what type of information is "material." Judging which information is "material" and therefore requires public disclosure can be difficult, and if the information is deemed "material," Regulation FD now imposes costly disclosure requirements.
The foregoing discussions highlight the need to examine going private in the wake of Sarbanes-Oxley and the downturn of the public capital markets. What follows is a short primer on the fundamentals of going private.
A Short Guide to Going Private
"Going private" is a corporate transaction in which either a group of individuals within the company or outside investors acquire the controlling equity interest of the company. Often these transactions are financed through private equity firms. Private equity firms are comprised of qualified investors who have pooled their money to enable them to purchase substantial equity interests in companies.
Going private transactions are governed by Rule 13e-3, which requires detailed disclosures as to their fairness. Rule 13e-3 supplements, rather than supplants, other SEC filing and disclosure requirements such as those for a Regulation 14D tender offer. Consequently, the disclosures required by Rule 13e-3 will ordinarily be included in a proxy statement, prospectus or offer to purchase required by other statutory provisions or rules. Under Regulation M-A, effective January 24, 2000, the SEC amended the rules to allow for one filing to satisfy the tender offer and going private disclosure requirements.
Going private can be accomplished in a number of ways, including an (1) open market purchase, (2) a Regulation 14D tender offer, (3) a cash-out merger which follows the Regulation 14D tender offer, (4) a leveraged buy-out ("LBO") or management buy-out ("MBO") or (5) a going private employee stock ownership plan ("ESOP").
Open Market Purchase: An open market purchase occurs when a company or outside investors buy the company's stock on the open market. In general, these purchases are effectuated without identifying the purchaser of the shares. In the case of the company purchasing its own stock, the company's board of directors must approve the purchase as well as set a maximum number of shares to be purchased and instruct management to comply with Regulation M and Rule 10b-18, SEC rules that avoid market disruption.
Regulation 14D Tender Offer: A Regulation 14D tender offer is a tender by the company or outside investors to buy the company's outstanding shares from some or all of the company's shareholders. The tender offer can take a number of forms, including the popular "Dutch auction tender offer." Under this method, the company or investor specifies the number of shares it plans to buy, asks shareholders to tender their stock within a specified range of prices and then determines the lowest price at which it can purchase the number of shares it wants and buys at that price.
Cash-Out Merger: A cash-out merger often follows a successful Regulation 14D tender offer where the party making the offer obtains effective voting control. The merger forces minority shareholders to exchange their unsold or non-tendered shares for cash. Under many state statutes, including Delaware's General Corporation Law, a merger may be authorized by a simple majority of shareholders (though charter documents may require a higher "super-majority"). The remaining minority shareholders are bound by the terms of the merger, although they may have "appraisal" rights to challenge the fairness of the cash payment.
LBOs/MBOs: An leveraged buy-out is an acquisition in which the company is taken private by a group of outside investors who finance the acquisition of the company's publicly-held shares on the credit of the assets of the company being acquired. Typically, the group of outside investors create a new shell entity to raise the necessary funds and to acquire the target company. Often, the outside investors offer the company's management a significant participation in the proposed buy out of the company and give them an equity interest in the company after the acquisition. An MBO involves the existing company's management forming an entity to borrow against the company's assets to finance the buyout of the public shareholders. LBOs and MBOs may utilize any of the methods described above to buy out the public stockholders.
Going Private ESOPs: A company may use its existing ESOP or form an ESOP to finance the purchase of its publicly owned shares with the ESOP's pre-tax cash flow. In a going private ESOP transaction, the ESOP borrows the necessary money, having the loan guaranteed by the company, and uses the money to purchase the company's stock. The purchased stock is then pledged to the lender, and the company then uses the proceeds from the sale of its stock to the ESOP to pay off the debt. This allows the company to amortize the debt with pre-tax dollars. ESOPs can also be utilized to facilitate going private tender offers. In this situation, the ESOP uses the proceeds from the loan to buy the company's stock directly from the public stockholders.
Companies that choose to go private today may find that, if they are able to successfully grow their business, they may be able in three to five years to sell the company at favorable multiples or re-enter the public capital markets and reap the attendant benefits.
Carter Ledyard & Milburn LLP is assembling a team of private equity investors, valuation experts and other service providers to help public companies evaluate whether going private makes sense. Questions regarding Sarbanes-Oxley and going private may be directed to Alan J. Bernstein (212-238-8795 or firstname.lastname@example.org). Jennifer G. Palmer (New York admission pending) assisted in the preparation of this advisory.
Michael J. Levitin and Steven S. Snider, "Going Public: Been There, Done That, "Going Private" Now", Washington Business Journal, October 18, 2002.
The Act's audit committee requirements only apply to companies with securities trading on the NYSE, AMEX and NASDAQ. The OTC Bulletin Board system does not currently have audit committee requirements. However the BBX, a new market for small companies which is slated to replace the OTC Bulletin Board in late 2003, will enforce the Act's independent director/audit committee requirements. See http://www.bbxchange.com/FAQS/
Tamara Loomis, "Sarbanes-Oxley Burdens Small Companies", New York Law Journal, December 23, 2002.
Carter Ledyard & Milburn LLP uses Client Advisories to inform clients and other interested parties of noteworthy issues, decisions and legislation which may affect them or their businesses. A Client Advisory does not constitute legal advice or an opinion. This document was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.
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