Do public company woes concern private companies? Scandals, Sarbanes-Oxley and the implications for private companies.

Since Enron's implosion, the environment for public companies has changed radically. Regulators, courts, institutional investors and plaintiffs' lawyers are taking a closer look at actions by the boards of directors and officers of public companies. Owners and executives of private companies should not relax and assume that they will not be affected by this new legal and regulatory environment. The scandals that shook Enron, Worldcom and other public companies have changed the standards applicable to all companies, public and private.

In light of this changed environment, private companies should consider the new standards imposed on public companies. The extent to which a particular private company will embrace these standards will vary depending on its size, ownership and industry, though every private company will be affected to some degree. Private companies with institutional and other outside shareholders will be under more pressure to adopt reforms than companies entirely owned by founders and their families. Similarly, companies looking to go public will need to be more sensitive to these issues. A private company's failure to heed the changes initiated with the public company scandals may result in unexpected trouble. Private companies should consider the following:

Sarbanes-Oxley Act 

The Sarbanes-Oxley Act (or "SOX"), adopted by Congress in response to the scandals, is primarily directed at public companies, but two of its provisions are not so restricted. SOX requires all companies, public and private, to retain records related to any actual or threatened investigation of itself or someone else, such as a business partner, vendor or customer. Also, SOX makes it a crime to retaliate against a whistleblower.

SOX has also changed how public companies prepare their financial statements. SOX requires officers of public companies to certify the accuracy of financial statements. Though certifications are not legally required for private companies, if the CEO or CFO of a private company adopts the mindset that he or she may need to sign such a certification upon request by the company's board of directors, the officer will likely take extra care to be sure that the financial information is correct and, at a minimum, will not turn a blind eye to problems.

SOX also mandates the establishment of independent audit committees for public companies. Though small or family-owned companies are unlikely to need or want independent audit committees, companies with outside investors or which are considering going public should consider this step. Management controls the preparation of financial information and usually interfaces with the auditors. Having an independent body in the company with direct responsibility for appointing, compensating and overseeing the work of the auditors provides a valuable check on management.

Increased Director Oversight

Recent events have changed the very nature of corporate governance. Courts are more closely scrutinizing director actions and requiring greater oversight by boards. In particular, directors of public companies are being required by courts to actively exercise independent judgment in reviewing CEO actions. As with other areas, this higher standard will find its way to private companies.

Dealings with Third Parties

Business Alliance Suits

A company may find itself being sued if it allows its vendors, customers and others with whom it does business to utilize it as a pawn in carrying out an improper scheme. Disgruntled shareholders and creditors of public companies are suing business partners of public companies when the business partner, by participating in a transaction, allows phantom revenues or profits to be created for the public company or other dubious financial results to be achieved. Although one company cannot oversee how another company accounts for its transactions, a company should hesitate before entering into transactions susceptible to claims of improper financial engineering.

Policy Statements

Mutual funds which have allowed market timing in violation of their stated policies have been targeted by the SEC, state regulators and fund investors for violating those policies. If a company has a publicly stated policy (including codes of conduct, mission statements, and the like) upon which third parties rely in their dealings with the company, and the company violates that policy, the company may be liable for fraud or misrepresentation. This expanding scope of civil liability for public companies will apply equally to private companies who represent that they abide by published policies but fail to do so.

Conclusion

A private company's desire to sit back and watch but do nothing, as public companies undergo increased scrutiny and are subject to greater restrictions and regulations, is understandable but unwise. The changes imposed on public companies by Congress, regulators and courts have changed, and are continuing to change, the standards. These heightened standards will apply, at least in some version, to private companies. Private companies should take heed now and begin to institute appropriate changes in order to avoid future problems.

Gregory C. Fant is a partner in the Los Angeles office of Arnold & Porter LLP and specializes in the representation of closely held businesses.