I N S I D E
T H E
M I N D S
Compliance Issues
and Trends
Leading Lawyers on Evaluating Benchmarks,
Educating Clients, and Mitigating Risks
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Corporate Governance for
Public and Private Companies
Ivan M. Diamond
Senior Member
Greenebaum Doll & McDonald PLLC
Inside the Minds – Published by Aspatore Books
The Value of Corporate Governance for Private Companies
I advise a broad range of both public and private corporations on corporate
governance issues, and while there is some overlap with respect to those
issues, there are also some major differences between corporate governance
practices for private companies versus those that are publicly held. For
example, the Sarbanes-Oxley Act of 2002, Pub.L. 107-204, 116 Stat. 745
(July 30, 2002), adopted in the wake of the devastating collapse of Enron
and WorldCom, deals with everything from corporate board responsibilities
to criminal penalties and provides the basis of many corporate governance
rules for public companies, but its regulations do not apply, for the most
part, to private companies (e.g., the criminal penalties and civil fines
adopted in Sections 802, 904, and 1107 apply equally to both public and
private companies). Also, many corporate governance requirements are the
product of listing requirements of public securities exchanges and do not
apply to private companies.
However, there are many reasons for private companies to have good
corporate governance practices similar to those under Sarbanes-Oxley.
First, having a corporate governance program in place is necessary for an
exit strategy. If you do not have good corporate governance, you may be
impeded from either selling your company or going public. This is because
the absence of good corporate governance practices can be a red flag that
will frighten potential purchasers, and in the alternative, the cost of
adopting, all at once, the corporate governance requirements for public
companies, in addition to the costs of an initial public offering, can be costprohibitive. In addition, if a private company ever needs either equity or
financing, those types of investors will be looking for adequate financial
statements, independent boards, competent and independent audit
committees, and senior management accountability as a prerequisite to their
involvement. Sarbanes-Oxley stipulates that a public company’s chief
executive officer and chief financial officer must sign a certificate with their
U.S. Securities and Exchange Commission filings to the effect that all of the
company’s disclosures, including disclosures of related party transactions,
are correct and complete, and while not subject to Sarbanes-Oxley, private
companies are increasingly expected to demonstrate the same type of
accountability through a variety of outside pressures. Even non-profit
corporations are facing increasing pressure to adopt good corporate
Corporate Governance for Public and Private Companies – By Ivan M. Diamond
governance practices, primarily with respect to stricter accounting oversight
and accountability.
There has even been some case law holding directors of private companies
liable for not properly giving oversight to the company with respect to
letting illegal activities go on, either knowingly or unknowingly. See John S.
Pereira (Trustee of Trace International Holdings Inc.) v. Cogan et. al., 294 B.R. 449
(S.D.N.Y. 2003); Growe v. Bedard, 2004 WL 2677216 (D. Me. 2004). Indeed,
many people do not want to be corporate directors these days because of
the liability that is involved. However, there is pressure on even privately
held companies to have some outside directors. Therefore, I have advised
some of my clients to hire advisory board members who would not have
the same liabilities as a director, yet they would bring an independent
perspective to the business. In addition, advisory board members are easier
to recruit because they have less liability, and they do not have to devote as
much time to the business.
Another reason for a private corporation to have good corporate
governance is because the state corporate laws under which every company
is incorporated do not distinguish between public and private companies,
and state law cases concerning the proper exercise of a company’s fiduciary
duty are starting to reflect what I would call the higher expectations of
directors and corporate fiduciaries that have been brought about by the
passage of Sarbanes-Oxley and all of the corporate scandals of the 1990s.
Corporate Governance Best Practices for Private Companies
When developing corporate governance practices for private companies, I
always recommend that the chief executive officer and chief financial
officer provide some attestation that they will be responsible for their
company’s financial statements. Such attestations need not be as formal as
those required under Sarbanes-Oxley. I recommend that private companies
establish whistle-blower procedures, similar to those required under
Sarbanes-Oxley. Under these procedures, a whistle-blower who reports
violations of law or other serious transgressions by another employee,
officer, or director can remain anonymous, and there is no retribution
against the employee for whistle-blowing.
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I have seen the adoption of various financially focused corporate
governance policy guidelines in many private companies. For example, most
larger private companies have already adopted audited financial statements,
independent director positions, disclosure of critical accounting policies and
estimates, and disclosure of off-balance sheet and contingent liabilities.
Looking back to the WorldCom and Enron scandals, and even today with
respect to the mortgage-backed security crisis, having opaque financials no
one can understand and off-balance sheet liabilities that are not clearly
disclosed demonstrates very poor governance. Therefore, even private
companies must start to bring some clarity to their financial statements,
especially if they wish to raise money at any point in time.
Larger private companies should also review the operations of their
employee benefit plans to comply with the Employee Retirement Income
Security Act of 1974, as amended, Pub.L. 93-406, 88 Stat. 829 (September
2, 1974), fiduciary reporting requirements, and disclosures. Under
Sarbanes-Oxley, there are criminal penalties for violating some of those
provisions, including blackout requirements that do not permit the
officers and directors to trade in a company’s stock at a time other
employees cannot do so.
Governance Issues and Trends for Public Companies
For public companies, there seems to be a growing movement toward
shareholder-favorable corporate governance. Much of this is endemic to the
rise of the institutional investor over the past ten years, but it is also a
byproduct of the growing sentiment that boards of directors have been at
the heart of much of the corporate malfeasance and major corporate
collapses of late.
One of the biggest corporate governance issues currently pertains to
majority voting for directors. Plurality voting in the election of directors is
the default standard in most states, as well as under the Model Business
Corporation Act. Plurality voting means a director is elected to office by
virtue of having received the most votes in an election. Some corporate
activists have said it is unconscionable corporate governance to allow only a
plurality of shareholders to elect a company’s directors because it can result
in situations where directors are chosen by a ridiculously small percentage
Corporate Governance for Public and Private Companies – By Ivan M. Diamond
of the total shares eligible to vote on the matter. Plurality voting also has a
major impact on the prevalence and strategy behind proxy contests for
control of public company boards. In response to the criticism, many large
companies have already passed amendments to their articles of
incorporation requiring majority approval for directors. In addition, the
Model Business Corporation Act and the Delaware General Corporate Law
were amended in 2006 to facilitate majority voting, and leading proponents
of majority voting continue to lobby for the change.
Another recent issue for public companies in the corporate governance area
is the push to abandon any practice that appears to entrench current
management and directors. Two practices are challenged most often. The
first is the “poison pill” practice, adopted by many companies starting in the
1980s and 1990s. If a person acquires more than a threshold percentage of
a company’s stock, 15 percent for example, without prior board approval of
the target, the purchase will trigger the poison pill, which permits all other
shareholders to purchase large amounts of shares at a nominal per-share
price. This would result in the acquiror’s ownership being greatly diluted.
Consequently, no acquiror has ever actually purchased enough stock to
trigger a poison pill. In most cases, these poison pill contracts last for a tenyear period, and when they expire they come up for renewal by the board.
However, there have been a number of proposals by shareholder activists
that companies should not renew those poison pills because they serve to
entrench management. Consequently, many larger companies have chosen
not to renew them.
Activists have also challenged classified boards of directors, in which onethird of the board comes up for election every three years. This is viewed as
a practice that protects and entrenches current management. Therefore,
many companies that have classified boards are amending their articles or
governing documents to get rid of this voting practice, and to elect all
directors on an annual basis. As a result, if shareholders are dissatisfied with
their directors, they can throw them all out at once, instead of having to
wait to elect a portion of the directors at three-year intervals.
Another governance issue for public companies is director independence.
Both the New York Stock Exchange and the NASDAQ require that a
majority of a public company’s directors be independent, and many
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shareholders activists have said a public company’s board should be mostly
independent, not just a bare majority. In response, some companies are
passing more stringent standards for their own boards than the exchanges
require (i.e., stipulating that 75 percent of their directors be independent). I
have several public company clients that have only one or two management
directors, such as the chief executive officer and one other insider.
Board leadership is another important governance issue for public
companies, especially with respect to separating the functions and duties of
the chairman and the chief executive officer. Many corporate activists
believe too much power is bestowed on a chief executive officer who is also
chairman, and that this situation has resulted in a number of vastly
overcompensated chief executive officers, even when the company is not
performing well. At this time, however, probably less than 25 percent of
public companies have a separate chairman and chief executive officer, and
far fewer have written binding policies requiring the separation of those
positions. Moreover, most of those companies that have a separate chief
executive officer and chairman do not have a written policy that requires
those positions to be separate.
Additionally, there has been a push in recent years toward stock ownership
guidelines for officers and directors. In the 1990s and early 2000s, many
corporate officers and directors enjoyed steadily increasing compensation
with mega stock option grants, and as soon as the options vested, the
company’s officers would exercise all of their options, immediately sell the
stock, and pocket the money. However, many corporations are now
requiring their officers and directors to hold some percentage of their
shares for the long term, based on a multiple of their salary or
compensation, so they will be in the same position as the other
shareholders. Indeed, if all you have is options, you are not really in the
same position as the other shareholders, because if the company’s stock
goes down, you have no downside. Options have no actual money at risk
until they exercise their options (i.e., loss of potential profit does not equal
the loss of your investment).
I am also seeing a lower percentage of equity compensation in stock
options. The stock option compensation is being replaced with smaller
amounts of restricted stock that are economically equivalent to a larger
Corporate Governance for Public and Private Companies – By Ivan M. Diamond
amount of options. Under this arrangement, a director actually gets the
company’s stock instead of options, and many think this practice more
appropriately aligns the director’s interest with that of the long-term
shareholders.
The Role of Outside Directors and Financial Experts
Since the passage of Sarbanes-Oxley, and in response to all of the corporate
scandals of the past decade, there has been an increase in the
responsibilities of independent outside directors, including those who serve
as financial experts. Along with a real increase in the amount of time that
goes into the job of being an outside director, there has been a consequent
increase in director compensation, because it is increasingly difficult to find
qualified directors, especially for smaller public companies.
Although Sarbanes-Oxley did not directly require companies to hire a
financial expert for their audit committees, it did so indirectly by stipulating
that if you do not have one, you have to disclose why you do not have one
in your proxy statement. While the Securities and Exchange Commission
claims it only requires disclosure, not conduct, the reality is that the
commission very much governs conduct in this area, because few
companies would be happy to disclose that they do not have a financial
expert on their audit committee. Indeed, although the Securities and
Exchange Commission stipulates that companies must have at least one
financial expert on their audit committee, many larger companies now have
more than one.
The demand is so high for financial experts that qualified directors often
wind up getting too many offers. Consequently, Institutional Shareholder
Services has recommended a limitation on the number of board audit
committees a director can serve on as a financial expert. Institutional
Shareholder Services will now recommend a vote to reject a director if he
or she serves on more than two other boards besides his or her own, based
on the belief that you cannot possibly do all the work necessary to be an
informed and effective director if you are sitting on too many company
boards.
Inside the Minds – Published by Aspatore Books
In addition, a New York Stock Exchange listing rule states that if you are
on more than three audit committees, the board must determine that your
simultaneous service would not impair your effective service as an audit
committee member. Many companies have gone beyond this ruling by
saying they will not appoint a director as an audit committee member if the
director is a member of more than one or two audit committees of other
companies. I think this is a wise practice, because being an audit committee
member is a tough and time-consuming job, and you cannot really do the
job properly if you are spread too thin.
The Costs of Governance for Public and Private Companies
Compliance and corporate governance has a wide range of costs, depending
on what practices you implement. I have seen companies spend from
$50,000 for some smaller companies to millions of dollars in order to
comply with Sarbanes-Oxley Section 404. Section 404 requires management
and the external auditor of a public company to report on the adequacy of
the company’s internal control over financial reporting. Under Section 404,
management must adopt appropriate internal control procedures. The
company is also required to produce an internal control report as part of its
periodic disclosure, which contains an assessment of the effectiveness of
that internal control structure and the procedures of the issuer for financial
reporting. All of this requires extensive labor by executives, accountants,
and legal professionals.
Obviously, the cost of compliance for a small company is disproportionate
to the cost for a larger company. Indeed, for some small companies, the
cost of Sarbanes-Oxley compliance literally represents the difference
between a loss and a profit for the year. I have even seen some small public
companies go private because of the expenses of being a public company
since the passage of Sarbanes-Oxley. Fortunately, the Securities and
Exchange Commission has recognized that the costs of implementing
internal controls fall disproportionately on small companies. Therefore, in
recent years it has moved to make the procedures that are necessary to
verify a smaller company’s internal controls and financial statements much
more reasonable and less costly.
Corporate Governance for Public and Private Companies – By Ivan M. Diamond
It is important for all companies, public and private, to balance their
governance controls with an understanding of the costs that good
governance requires. To that end, I have encouraged both my public and
private company clients to put financially literate directors on their boards
and audit committees, although it is generally easier for a larger company to
do so than a smaller company.
International Governance and Compliance Issues
Corporate governance practices in other nations differ greatly from our
own in many cases, and our companies often compete with foreign
companies that operate under lesser governance standards than those
found domestically. For the first time ever, recent years have seen more
money raised and more initial public offerings in London than on Wall
Street. We are also seeing the emergence of Asian markets such as those
in Hong Kong and Shanghai, and even Dubai is vying to become a
major financial center. Simply put, the lesser governance standards in
these nations are attracting more initial public offerings and more
listings.
However, this trend is a two-edged sword, because many foreign
companies are becoming more comfortable with the new U.S. rules, and
as the Securities and Exchange Commission cuts back some
requirements for smaller public companies and makes the costs of
compliance with Sarbanes-Oxley more realistic, we are seeing a number
of foreign issuers who are willing to pay the money to come to the U.S.
stock exchanges and U.S. capital markets. Indeed, some companies like
the fact that there is more governance and more transparent disclosure
in our markets.
As the world marketplace becomes increasingly international, I believe our
corporate governance standards are affecting the rest of the world, and the
rest of the world’s standards are affecting ours as well. Consequently, we are
probably heading toward the creation of international governance standards
in an increasingly smaller world market.
Inside the Minds – Published by Aspatore Books
Looking to the Future: Challenges and Changes
The issues that are involved in financial statement vetting under SarbanesOxley will remain a major challenge for many companies going forward,
because it is a costly and complicated process. It takes a lot of hard work to
understand the financial statements of a company, and there are increasing
liability issues with respect to not knowing what is going on in a company
where you serve as a director.
Another major corporate governance principle going forward is the process
of reporting up the chain with respect to any financial or other
improprieties you see. If in-house legal counsel sees something wrong going
on in their company, they are required to report it up the chain, and if the
chief executive officer will not do anything, counsel may have to go directly
to the board of directors or chairman of the audit committee. Again,
companies must have corporate governance policies including
whistleblower protections that promote and spell out how you should
report suspected violations.
Finally, I believe that in the wake of the recent credit crisis, it is clear that
financial institutions are going to be increasingly scrutinized in the years to
come, and this might, as recently indicated, cause the wholesale renovation
of much of the current regulatory framework and the concentration of
regulatory power with regard to our financial markets. Clarity with respect
to a company’s or a bank’s financial statements is essential, because highly
leveraged and complicated financial engineering can hide the true liabilities
or obscure the true risks of a business. Increasing the transparency of
financial reporting and financial instruments is a daunting challenge we are
currently facing, and this area clearly will provoke great changes we are
likely to see in terms of governance and government regulations in the years
to come.
Corporate Governance for Public and Private Companies – By Ivan M. Diamond
Ivan M. Diamond of Greenebaum Doll & McDonald PLLC is the banking and
financial company’s team co-chair and the securities team co-chair. He was an attorney
with the Securities and Exchange Commission in Washington, D.C., prior to joining the
firm. He has represented a wide range of companies in connection with the numerous
public and private offerings of equity and debt securities and mergers and acquisitions
totaling billions of dollars. He counsels boards of directors on corporate governance and
Sarbanes-Oxley Act compliance. He has represented corporations in numerous complex
transactions, including takeovers, takeover defense, spin-offs, and going-private
transactions. He has advised financial institutions in more than a hundred acquisitions
and restructuring. He has been involved in a number of complex transactions and
regulatory compliance with troubled financial institutions. His clients have also included
companies in health care, restaurants, manufacturing, oil and gas, and real estate.
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