Professor Bainbridge...on law, politics, religion, culture & food

Best Practices in Public versus Private Companies

In my The Complete Guide to Sarbanes-Oxley, I noted that close corporations have come under a variety of pressures to be SOX compliant:

Only two of Sarbanes-Oxley’s provisions apply directly to non-reporting corporations: (1) The protections for whistleblowers and (2) the prohibition of destroying, altering, or falsifying documents so as to prevent their use or discovery in any official proceeding. ...

The universe of closely held for-profit corporations ranges from giants like Cargill (with over $66 billion in revenue and 115 thousand-plus employees in 2005) down to the proverbial mom-and-pop. Technically, so long as they are non-reporting companies, none of these corporations are obliged to comply with SOX.

Larger close corporations, however, face a number of pressures to “voluntarily” comply with the main SOX provisions: First, larger close corporations often have at least some independent board members, who may see SOX compliance as a way of limiting their liability exposure and enhancing their ability to oversee management. Second, larger close corporations often use one of the Big Four accounting firms for auditing or other services. These firms reportedly are pressuring their non-reporting clients to develop policies for substantially complying with SOX’s core provisions. Finally, close corporations considering going public in the near future will be required to be SOX compliant thereafter and, accordingly, typically begin implementing SOX’s mandates even while they are still private.

There is no bright line that divides close corporations that ought to be SOX compliant from those that need not do so. As a rule of thumb, however, many lawyers and accountants suggest that any company with annual revenues of $50 million or more should seriously consider implementing at least the basic SOX mandates, especially those relating to auditor independence and effective internal controls.

An interesting new paper by Jennifer Johnson argues that the pressure for such firms to be SOX compliant is unsound:

While the regulation of internal corporate governance has historically been the exclusive province of state law, federal mandates now require independent directors to play the central role in the oversight of American corporations. While the federal regime primarily applies to public companies, some provisions, including the requirement of independent directors, are now touted as ?best practices? for private entities as well.

This paper suggests that this trend is ill-advised given the different roles that outside directors play in closely held firms. Whatever the virtues of independent directors as effective board members of public corporations, this is not a situation where what is good for the goose is necessarily good for the gander. In the private realm, the primary function of a board is advising, not monitoring. The federal mandates constraining the definition of director independence may unduly hamper the development of many private entities. Unlike the emerging federal regulatory scheme, state statutes rarely dictate board composition. State law provides incentives, however, for corporations to utilize independent directors by providing more deferential or limited judicial review of certain decisions made by independent board members. The state law definitions of “independence” are contextual but like their federal counterparts, the state definitions often miss the mark in dealing with private entities.

This essay evaluates the appropriate definition and role of independent directors in the context of private companies and suggests that true independence is not only illusory in such circumstances, but perhaps counterproductive to the best interests of the firm. This essay claims that for private entities, the choice of individuals to serve as outside directors should not be dictated by federal concerns, nor should the decisions of these nominally independent directors automatically enjoy the presumptions and protections now afforded under state law.