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Pre-IPO software companies: meet the Sarbanes-Oxley Act
By William Gehrke, Senior Partner, Hale & Dorr
Private Company Implications of New Public Company Rules
In the wake of well-publicized corporate scandals involving management self-dealing and accounting fraud, in July 2002 President Bush signed into law the Sarbanes-Oxley Act of 2002. The Sarbanes-Oxley Act—the most far reaching legislation affecting the federal securities laws since they were created in the 1930’s—impacts everything from the role of auditors to public reporting of stock trades by management, from committee independence to reporting of off-balance sheet transactions, and from officer loans to employee whistleblowing.
The Sarbanes-Oxley Act significantly increases penalties for white-collar crimes such as securities fraud, with maximum jail terms that now exceed the penalties for crimes such as armed robbery, assault with a deadly weapon and negligent homicide. The Sarbanes-Oxley Act also created several new crimes: retaliation against whistleblowers; destruction of documents and other obstruction of justice offenses; fraudulently influencing the company’s auditors; and a new substantive securities fraud offense.
Public companies are facing dramatic changes in disclosure and corporate governance requirements under the Sarbanes-Oxley Act, and under new and proposed rules from the SEC, NASDAQ and the NYSE. While these new rules and regulations do not generally cover private companies, their influence on private companies is being felt in the following ways:
The Sarbanes-Oxley Act may result in increased scrutiny of a private company being considered for acquisition by a public company.
A private company will become subject to the Sarbanes-Oxley Act upon filing a registration statement with the SEC in anticipation of an IPO.
The boards of directors and management of many private companies are embracing various aspects of the Sarbanes-Oxley Act as “best practices.”
Familiarity with these new rules will help private companies avoid pitfalls that could interfere with important future milestones, such as an acquisition or an IPO, and will contribute to the foundation of a company culture of fiscal and corporate responsibility.
Prohibition on Personal Loans
The Sarbanes-Oxley Act prohibits public companies and companies in registration for an IPO from extending, maintaining, renewing or arranging personal loans to any director or executive officer. Loans that existed on July 29, 2002 are permitted to remain outstanding, so long as they are not materially amended. Upon the filing of an IPO registration statement by a private company, all outstanding loans made after July 29, 2002 to a person who is a director or executive officer of the company at the time of filing will be illegal.
Private companies should consider prohibiting loans to officers and directors or requiring that any loans made or modified after July 29, 2002 be repaid immediately prior to the filing of an IPO registration statement if at that time the borrower is a director or executive officer. In addition, private companies should consider adding, as a condition of a loan, the requirement that an acquisition of the company by a public company be considered as triggering repayment of the loan, if the borrower becomes a director or executive officer of the acquiring public company.
Private companies should bear in mind that the company might have to forgive such a loan upon the filing of a registration statement, since repayment may not be practical given that there will not yet be a public market for the company’s stock at the time the loan must be repaid. Also, forgiving loans extended for the purchase of stock may result in unfavorable accounting treatment.
Stockholder Approval for Stock Plans
The NYSE has proposed a rule prohibiting discretionary voting by brokers on stock plan proposals and instead allowing brokers to vote customer shares on stock plan proposals only pursuant to customer instructions. Although this is a NYSE rule, it would affect NASDAQ companies as well, since it would apply to voting by all brokers and dealers that are members of the NYSE, regardless of whether the shares being voted are shares of a NYSE-listed company.
This rule change may make it significantly more difficult for public companies to obtain stockholder approval of stock plans. This issue underscores the need for a company contemplating an IPO to evaluate whether it needs to increase the number of shares covered by its employee stock option plan and whether it wishes to adopt any new stock plans—such as a director stock option plan or an employee stock purchase plan—and to obtain the necessary stockholder approval for any such plan amendment or new plan while it is still a private company and stockholder approval is easier to obtain.
Board of Directors and Board Committees
Private companies should be aware of the rules relating to the composition of a board of directors and board committees, and should be prepared to be in compliance with these rules prior to filing an IPO registration statement. Of particular importance will be the need to have qualified independent directors—a requirement that will become increasingly difficult to satisfy, as increasing legal risks and director responsibilities, as well as increasing financial expertise requirements, could diminish the pool of willing-and-able participants.
Board Independence. Proposed NASDAQ and NYSE rules require that at least a majority of the directors be independent.
Audit Committees. The Sarbanes-Oxley Act and stock exchange rules impose heightened requirements for audit committee composition and impose additional responsibilities on the committee:
Compensation Committees. Both NASDAQ and the NYSE have proposed that compensation committees must consist solely of independent directors.
- Independence. The Sarbanes-Oxley Act, NASDAQ and the NYSE each require that all members of the audit committee be independent. Of note is a proposed NASDAQ rule that would prevent 20% stockholders from being considered independent, which may disqualify some of a company’s venture capitalist directors from serving on the audit committee. A proposed SEC rule would provide that persons owning less than 10% of a company’s stock would not be precluded from being considered independent for audit committee purposes by virtue of their stock ownership.
- Financial Expertise. Current NASDAQ and NYSE rules require all audit committee members to be financially literate, and at least one member to have accounting or financial management experience. The Sarbanes-Oxley Act requires companies to disclose in their Form 10-Ks whether the audit committee is comprised of at least one member who is an “audit committee financial expert.” The SEC’s definition of audit committee financial expert requires that the person have specified accounting expertise that is generally acquired either through experience as an accountant or as CFO or controller, or through experience supervising such a person.
- Responsibilities. The audit committee has the direct and sole responsibility for the appointment, compensation and oversight of the company’s auditors. The audit committee is also responsible for pre-approving audit services and any non-audit services not prohibited by the Sarbanes-Oxley Act.
- Accounting Complaint Policy. The Sarbanes-Oxley Act requires that the audit committee adopt and implement procedures for receiving and handling complaints regarding accounting matters, including the confidential and anonymous submission of employee concerns regarding accounting matters.
Nominating Committees. NASDAQ has proposed requiring that all director nominations be approved by a nominating committee consisting of independent directors or a majority of all independent directors. The NYSE has proposed that each listed company must have a nominating and corporate governance committee consisting solely of independent directors.