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Part II Public Markets SOX

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Part II: Corporate Governance after Sarbanes-Oxley and a Word on Alternative Markets

The Sea Change of 2002

About once a decade the whole panoply of the SEC’s disclosure and securities market regulation becomes subject to an attempt at a major overhaul. Usually the changes that take place are really only fine-tuning. But 2002 was a very different year. After 9/11 came Enron and a severely depressed stock market combined with the lowest bond interest rates in 30 years. In the 12 months starting just before 9/11, the SEC brought more enforcement actions than in any similar period in decades, obtained orders for the disgorgement of illegal gains in excess of $900 million, proposed revolutionary controls over the accounting profession, and passed regulations mandating increased corporate governance. After a full year’s debate by securities and accounting professionals and the regulatory community, Congress passed the “Public Company Reform and Investor Protection Act of 2002,” the Sarbanes-Oxley Act (“Sarbanes-Oxley” or “SOX”). It became law on July 30, 2002. This is the first time the federal securities laws have mandated substantive law for corporate governance of public companies, other than audits and disclosures, or substantive governance of investment companies and certain public utility holding companies. The NASD, now read FINRA, has regulations which limit the “insider” nature of the underwriting business. Not since at least 1964 has there been such a major change in securities regulation.

Venture capitalists take heed. Now, when a venture capitalist negotiates the terms of his investment he will be well advised to make sure that the company’s board and financial controls meet the criteria of Sarbanes-Oxley from the start. As a practical matter, it may be too late if the corporate governance criteria of Sarbanes-Oxley and FINRA are not applied early on. It will not look good for a prospectus to have to disclose that the controls required by Sarbanes-Oxley were only instituted just before the company filed its registration.

As you will see, the SOX regulatory scheme can be onerous. SOX makes no few distinctions between large companies and small companies. If a public company files periodic reports with the SEC, it is subject to the SOX. However there are certain ways of limiting the effect of SOX on companies not listed on the NYSE or on NASDAQ.

Accounting Profession Regulation: Sarbanes-Oxley establishes the “ Public Company Accounting Oversight Board ” (“PCAOB”). The Board is a nonprofit corporation under the laws of the District of Columbia. The Board establishes:

…auditing and related attestation standards, such quality control standards, and …ethics standards to be used by registered public accounting firms in the preparation and issuance of audit reports, as required by the Act…

The law provides the PCAOB is not to be “an agency or establishment” of the government, but it might as well be, because failure to live up to its mandates has much the same effect as failure to live up to a government regulation; it will mess up the deal. In general the PCAOB operates much the same way as FINRA. All accounting firms which conduct audits of public companies must have to register with the Board. Through that registration, all accountants are required to meet professional standards and are registered with the PCAOB. The Board has promulgated regulations and enforces them through disciplinary proceedings. Like FINRA, its regulations and disciplinary proceedings are subject to approval by the SEC. Although auditing standards will continue to be suggested by the accounting profession’s industry body, the AICPA; the Financial Accounting Standards Board (”FASB”); and the state accounting societies, the pronouncements of the PCAOB govern.

The law provides that a registered public accounting firm that audits more than four public companies must change the partner in charge of the audits for a public company every five years. Also, registered public accounting firms are limited in their work for the public companies they audit to those activities deemed to be compatible with auditing. Therefore much of the consulting work that was performed by the firm that audits the books of the company prior to Sarbanes-Oxley now needs to be done by others. Non-auditing consultants can be retained to fulfill those functions. However, if approved by the audit committee in advance, the auditors can provide tax services to an extent not deemed incompatible with the audit function.

Audit Committees: With the exception discussed in the next paragraph, the board of directors must appoint an audit committee. This is quite onerous and can be very expensive. The committee must be composed of directors who are not otherwise affiliated with the company. The committee must be appropriated the amount of company funds, as determined by the audit committee, to carry out audits and the committee’s work. It must be authorized to engage its own independent counsel and other advisers, if it thinks it advisable. The auditors are to report in the first instance to the audit committee and then to the board of directors. The audit committee is expected to meet regularly with the auditors and be able to document its guardianship of the accounting of the company. Also, at least one member of the audit committee must be a person who is a “financial expert,” as that term is defined in Sarbanes-Oxley, or the company must disclose why no such person serves on the audit committee.

How does one avoid the big elephant in the door, the audit committee, with its disproportionate expense? Small companies, such as those on the OTCBB, can disclose in their SEC filings that the board of directors acts as an audit committee, and that there is no dedicated “financial expert” because of the expense in relation to the size of the company. However, beware of the corporate governance rules of whatever level of NASDAQ or the NYSE to which you aspire because that approach probably will not be acceptable.

Compensation and Nominating Committees: A compensation committee and a nominating committee must be established, but in small companies such as OTCBB companies, the board may perform these functions, as long as certain disclosures are made. Compensation of officers and directors of public companies is a very hot topic. The SEC received more public comment on its compensation proposals than on any other subject – ever. The rules of NASDAQ and the NYSE are much stricter on the issue of compensation and nominating committees than the SOX requirements.

Whistle Blowers: Whistle blowers are to be protected under Sarbanes-Oxley, and it requires an internal reporting system to the board which must be adhered to.

Officer Certification: SOX regulations now require the chief executive officer and the chief financial officer of public companies that file periodic reports with the SEC to individually certify the financial statements in their periodic reports. The law requires that the CEO and CFO:

shall certify the appropriateness of the financial statements and disclosures contained in the periodic report, and that those financial statements and disclosures fairly present, in all material respects, the operations and financial condition of the issuer.

In addition, the auditors, CFO and CEO must prepare, sign and file internal accounting control reports. The reports had better be right. If they are materially wrong, both the CEO and the CFO may be required to reimburse the issuer for any bonuses, and other incentive-based or equity- based compensation they received during the 12 months following the publication of the first inaccurate financial statement, and any profit they made on a sale of company securities during that period.

“Insider” Deals: Another affect of Enron is control of the financial dealings of directors, senior officers and other “insiders.” Insider trading during blackout periods of company pension funds is prohibited even if it is not based on inside information. Off-balance sheet transactions must be reported. Pro forma figures are subject to a 10b-5 type full rule. Personal loans to directors or executives, or arranging credit for them are prohibited except for home improvement loans, and loans of the type the company generally makes available to the public (like banks make loans) and any such loans must be made on market terms.

These provisions put a substantial damper on the exercise of options. It is now recognized that stock options provided to employees shortly before an IPO must be expensed. As an IPO becomes more likely, unless option prices are increased to at least one third of the expected IPO price, there will be a substantial hit to reported GAAP earnings. This problem can be avoided to some extent, but only your accountants can give you definitive guidance.

Code of Ethics: The SEC has also promulgated rules to require that every public reporting company either establish a

code of ethics for senior financial officers, applicable to its principal financial officer, comptroller or principal accounting officer, or persons performing similar functions

or explain why it has not established such a code. Small companies can usually make a declaration that they have not established such a code, but it is not difficult to establish a code and establishing a code is definitely the better way to go.

Securities Analyst: The independence of securities analysts employed by investment bankers or broker-dealers is now protected by requiring their reports to disclose any conflicts of interest, and any compensation they may receive as a result of the consummation of transactions.

Appropriations: All this costs money. When it passed SOX, Congress authorized an additional $776 million for the SEC’s budget, more than double what it has received in any of the prior ten years. The SEC has drastically increased its staff, although remaining rather lean considering its mission. For an interesting view of the SEC, click onto its website: and jobs.

The Time Frame: This is a simple gloss of a 63-page 12 pt type law. Consult knowledgeable counsel who keeps up with the regulatory framework. And now there is another series of changes in the works; this time through changes in the regulatory framework. These proposed changes are discussed below.

Considerations for the Initial Private Placement

Since a registration of securities cannot be filed without the consent and cooperation of the company, rights to registration and access to financial information must be negotiated as part of the initial private placement agreement.

Registration Rights: Frequently more time is spent on negotiating future registration rights in a private investment than on any other matter. In setting up the original transaction, the venture capitalist would like to have unlimited registration rights, i.e., to be able to have any number of shares registered whenever it wants, and to severely restrict management fantasies of having the same unlimited rights. In any case, both parties should recognize that the company must limit the number of registrations because of the time and expense, potential liabilities, and the restrictions on certain activities of firms in registration.

The venture capital investment agreement should always include the following terms with respect to registration rights of private investors.

  1. Registration rights should be transferable to a new group if the shares are sold privately.
  2. Investors must be indemnified by the investee against suits due to securities law violations by persons other than themselves and vice versa.
  3. The company should be required to supply the venture firm with at least unaudited, (but reviewed) quarterly statements, and audited annual financial statements complying with SEC Form 10-QSB and Form 10-KSB, even if it is not required by law to comply with these periodic reporting requirements.
  4. The company should agree to pay for its auditors and counsel to provide the appropriate opinions to the venture capitalist and/or underwriter as to sale of securities to the public.
  5. The company must agree to comply forthwith with the corporate governance rules of Sarbanes-Oxley to the extent the venture capitalists require.

The following are negotiable:

  1. Rights to piggyback on an initial offering, subject to the underwriter’s willingness to accept the shares
  2. Breathing period for the company after registration on its own behalf, e.g., a 90- to 180-day hold-off from forced registration
  3. Coordination of filing with availability of audited financial statements.
  4. Payment of expenses on piggyback and/or “demand” registrations and separate limitations on number of piggybacks and demands
  5. Length of time that the registration must be kept current
  6. Best efforts to qualify under blue sky laws in various states when deemed advisable by counsel because SEC pre-emption and notification filing are not deemed applicable
  7. Process of selecting an underwriter.

Despite all the negotiations, the ultimate determinant of whether the venture capitalists’ shares can be included in an issue or must be held off the market for some period will be the future underwriter’s perception of what it can sell.

Read More:
Part 1: Summary
Part III: The Going Public Process
Part IV: The Possibilities of Rule 144A; Rule 144; and Conclusion
Appendices: Typical S-1 Prospectus Format; Underwriter’s Due Diligence Procedures

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