Legal and Ethical Challenges for Entrepreneurs in the New Age of Scrutiny
Andrew J. Sherman, Partner, Dickstein Shapiro Morin and Oshinsky LLP
Since the collapse of Enron, Arthur Andersen, Worldcom, and the investigations at AOL Time Warner, Tyco, QWest, Global Crossing and other major companies, the public's trust in corporate leaders and financial markets has been virtually destroyed - the "public" meaning employees, shareholders and bondholders. Indeed, the market did not need a corporate governance crisis at this time. Plenty of other factors were already rattling the investor psyche: the threat of war with Iraq; fighting in the Middle East; threats of additional terrorist attacks on the United States; disputes between Pakistan and India - all of which were coupled with the market corrections suffered since March 2000. These challenges have "trickled down" to the private equity and venture capital markets, making it difficult for leaders of entrepreneurial companies to attract new growth capital.
What can be done to rebuild the public's trust and confidence and get the capital markets back on track?
At the heart of the solution lies the need to return to the fundamentals of what it means to serve as an executive or as board member of both a publicly traded company and a privately held growth company. Corporate governance laws created duties of care, duties of fairness (to avoid self?dealing and conflicts of interests), duties of due diligence, duties of loyalty, and the business judgment rule to help ensure that all who serve on boards, advisory councils or committees do so primarily for the purpose of serving others. In other words, their mission is to help, to guide, to mentor - to be a fiduciary and look out for the best interests of the company's shareholders - and not to perpetuate greed or fraud. Many corporate leaders seem to have somehow lost sight of their responsibility to the constituents the laws dictate they serve.
In response, Congress acted relatively swiftly (some say hastily) in passing the Sarbanes?Oxley Act, which President Bush signed into law on July 30, 2002. The Securities and Exchange Commission, the major stock exchanges and state attorneys general, among others, have also responded quickly to create more accountability by and among corporate executives, board members and their advisors to shareholders and employees. Central themes include more objectivity in the composition of board members, more independence and autonomy for auditors, more control over financial reporting, stiffer penalties for abuse of the laws and regulations pertaining to corporate governance, accounting practices and financial reporting, and new rules to ensure fair and prompt access to the information that affects the company's current status and future performance.
The Sarbanes Oxley Act of 2002 included the following key provisions:
- Creation of a Public Company Accounting Oversight Board to regulate public accounting firms and ensure auditor independence. The Board will be under the authority of the SEC.
- Stricter requirements for the independence of auditors and audit committees.
- Requirement that CEOs and CFOs certify financial statements, under threat of civil and criminal penalties for false certifications.
- Prohibition of loans to executives and directors.
- Accelerated reporting of insider trading.
- Blackout period for trading in retirement fund equities by directors and officers under Section 16.
- Increased disclosure requirements, including certain categories of information that must be disclosed rapidly and currently.
- Requirement that attorneys report material violation of securities law or breach of fiduciary duty to the chief legal counsel or CEO.
- Stricter civil and criminal penalties for securities and violations.
- Application of securities laws to foreign issuers.
Yes, we are truly entering a new age of scrutiny ? an era of validation and verification. The role of the board and its committees is being redefined, re?examined and re?tooled. A new set of best practices, procedures and protocols is being written as we speak, and this process will continue into 2003 and beyond. Internal controls and systems need to be designed to ensure compliance with these new rules of the game, and managers must be held accountable for enforcement and results. The CEO's new job description reads "Forget the Gravy, Where's the Beef' and includes less pay, less perks and less power in exchange for more performance and less tolerance for error or abuse. In short, CEOs must live in a new era that features more accountability and shorter tenure.
Yet, the key question remains: Can we truly legislate and mandate trust, integrity and leadership? Will new laws and stock exchange guidelines truly restore public confidence in the markets and get directors and officers focused on these higher standards of diligence, commitment and responsibility? How far does any proposed legislation still on the horizon need to go to get officers and directors truly focused on their most important task: maximizing bona fide shareholder value.
Under the new law, leaders of public companies owe a duty to their shareholders, employees and strategic partners to adopt new procedures and comply with these new requirements in order to avoid the widespread damage that is done when an entire corporation comes under legal attack and in the media spotlight for all the wrong reasons.
However, entrepreneurs and leaders of private companies should also be aware of the new corporate governance law, because the requirements are likely to have a "trickle down," or indirect effect, on non-public companies as follows:
- There is a new emphasis on accountability and responsibility in corporate America that affects board members and executives of companies of all sizes as shareholders look for better and more informed leadership.
- Some of the corporate governance provisions of Sarbanes-Oxley are likely to evolve into "best practices" in business management over the next decade. Other provisions merely reinforce state corporate law requirements that have already been in place for many years governing all corporations and limited liability entities. Since corporate law is generally made at the state level, entrepreneurs and owners of private companies should keep a close watch on developments in their state of incorporation.
- It is highly likely that insurance companies that issue D&O insurance and related policies will require some form of Sarbanes-Oxley compliance as a condition to the issuance of new policies or as a condition to obtaining favorable rates.
- Employees at all types of companies are generally placing a new focus on ethics and honest leadership as a condition to staying on board or loyal to the company regardless of whether it is regulated by Sarbanes-Oxley.
- Venture capitalists and other private-equity key players have a tendency to mimic developments in the public-equity markets when structuring deals and may begin inserting Sarbanes-Oxley-type provisions regarding executive compensation governance, auditor autonomy, reporting and certification of financial statements into their term sheets.
- Private companies that may be positioning themselves for an eventual sale to a public company will want to have their governance practices, accounting reports and financial systems as close to the requirements of Sarbanes-Oxley as possible in order to avoid any problems in these areas serving as impediments to closing. (In other words, get ready for a whole new level of due diligence questions in M&A that focus on governance practices and dig deeper into financial, compensation and accounting issues). As one senior vice-president of M&A at a large public company puts it: "We can now only afford to do deals which make our financial statements look better and will need to avoid the deals which have any potential negative impact."
- Board member recruitment at all levels is likely to be more difficult even for private companies given that the perceived risk of serving as a director is higher and the general cost-benefit analysis seems to fall short of accepting an offer. Once accepted, expect board members to be more focused, more vocal, more inquisitive and more likely to ask the hard questions and to want detailed and substantiated answers.
- Commercial lending practices are likely to change a bit in response to Sarbanes-Oxley for borrowers of all types. Be ready for conditions to closing and loan covenants which focus on strong governance practices, board composition issues, certified financial reporting, etc.
- In this new era, it is critical to build systems and procedures for better communications by and between the board and its appointed executives; the board and the shareholders, executives and employees; and the company and its stakeholders. Affected are companies of all types and sizes, regardless of whether shares are publicly traded. There is a renewed emphasis on independence, autonomy, ethical leadership, open-book management (see the writings of Jack Stack), accountability, responsibility, clarity of mission, full disclosure, that these systems and procedures need to create for all of corporate America.
- The requirements of Sarbanes-Oxley that must be adopted by public companies and understood by private companies are also beginning to make their way into the management and governance practices at non-profits, trade associations, business groups, academic institutions, cooperatives and even government agencies where any form of poor management, corruption, embezzlement or questionable accounting practices cannot be and will not be tolerated.
- Sarbanes-Oxley was passed, in part, to help restore confidence in the public capital markets. Until these laws have the intended effect and the public markets begin to rebound, entrepreneurs and executives at private companies are likely to continue to run into strong barriers to capital formation. The shrinkage in public company valuations and the virtual shut down of any exit strategies means that less venture capital and private equity capital deals will get done, especially for new projects, as opposed to follow-on investments to existing portfolio companies. When commitments are made, entrepreneurs should be ready for tougher terms and lower valuations.
- Getting deals done in general will be tougher in a post-Sarbanes-Oxley environment. Many of the highly acquisitive companies, such as. Tyco, Sun, and Cisco, have had their accounting practices called into question, and some of the biggest mergers (e.g. AOL-TimeWarner) do not appear to be working very well. The appetite for doing M&A deals seems to have faded, except for the value players, distressed company buyers and bottom fishers. The fraud behind Enron's many phony partnerships has even created some hesitation in the willingness of larger companies to partner with smaller ones in a joint venture or strategic alliance structure.
The bottom line here is that it is a brave new post-Sarbanes-Oxley world, and both public and private companies must adjust to this new reality.