By now just about everyone in corporate America has heard
about the Sarbanes-Oxley Act of 2002, which was enacted with much fanfare in
response to several notable corporate scandals involving large publicly held
companies.

In general, the Act was passed to address a slew of actual
and perceived deficiencies in corporate governance, financial statement
preparation and public disclosure practice. Despite the widely held notion that
the Act only applies to public companies, there are several provisions that
apply directly to private companies as well, such as requirements relating to
document retention and whistleblower protection.

More notable, however, are the other provisions of the Act
that apply exclusively to public companies, but may be imposed on private
companies by third parties interested in doing business with such companies. In
short, these provisions address matters such as board of director independence,
audit committee composition, codes of conduct and ethics, relationships with
auditors, internal controls over financial reporting, and management certification
of financial reports, among others.

Although these provisions do not apply directly to private
companies, there are many situations in which dealings with public companies
and other third parties will not be able to move forward unless voluntary
compliance with one or more of these provisions is undertaken.

The corporate governance requirements of the Sarbanes-Oxley
Act are quickly becoming recognized as “best practices” for all companies. They
are designed in many ways to enhance the integrity of a company’s operations
and increase the reliability of a company’s financial reports.

Accordingly, compliance with many of these provisions is
becoming more desirable, not only for companies engaged in major transactions
such as mergers and acquisitions, raising private financing and preparing to go
public, but also for those involved in more routine business matters, such as
securing bank financing, obtaining insurance coverage and contracting with the
government.

In each of these situations the failure to comply with
certain provisions of the Act, either in whole or in part, could delay or
prevent the matter from proceeding, or, in those cases where the matter does
proceed, significantly increase the costs involved or greatly reduce the value
or benefit ultimately realized.

In evaluating the approach to compliance, private companies
have several advantages over public companies, such as the ability to select which of the corporate governance
provisions should be complied with, when
such compliance should be phased in, and to what
degree should such compliance be undertaken.

With this flexibility a private company can implement a
customized compliance plan that best positions it for anticipated transactions,
while controlling the costs and labor involved.

Analytic Factors

Given the myriad requirements of the Act and the broad
spectrum of a private company’s activity that can be implicated, resolving
potential compliance issues can be a very complicated process involving an
analysis of factors including:

the size and
industry of a company;

the complexity of
a company’s operations;

how widely
dispersed the company’s operations are;

the anticipated
timing of engaging in an activity that raises compliance issues; and

the expectations
of the particular third party on the other side of a deal, which expectations
can be highly subjective and, therefore, vary widely.

Applying these factors is often not as intuitive as one
might think, since a large 200-person company with relatively simple business
operations may be a less likely candidate for compliance than a small 10-person
shop with complex operations.

In one simple scenario, if a private company believes it
might be a candidate for acquisition by a public company, or even by a private
company with aspirations of going public, then one requirement the target
should comply with relates to its internal controls over financial reporting.
That’s because each public company is required to make public disclosures about
certain of its financial and other information, which will necessarily include
any applicable information relating to acquired entities.

If the acquiring company is uncomfortable making the
required disclosures and attestations, it might not be willing to pay the price
originally proposed or, in the worst case, it might not be able to proceed with
the transaction at all. Further, if a member of the target’s management team
has a company loan outstanding, which has not been grandfathered, and the
member is expected to be added to the acquiror’s management team, the debt will
either have to be satisfied or forgiven (with the executive having to deal with
the resulting liquidity and tax consequences), or the executive may have to
forego appointment to the position.

Potential Compliance Issues

A variety of situations can raise one or more potential
compliance issues, including raising venture capital or other private financing
(whether or not to install an audit committee), obtaining bank financing
(whether or not to comply with board or committee independence requirements),
or obtaining or maintaining D&O insurance (whether or not to adopt a code
of ethics), to name but a few.

Of course, a company considering going public must deal with
a much broader range of compliance issues well before the first registration
statement is even filed. Notably, in just about every case, effectively
implementing compliance measures will require significant lead time, not unlike
the minimum nine-month to one-year period required to design internal controls
over financial reporting, implement them and evaluate them through financial
statement preparation cycles.

In light of the significant potential benefits that could
result from selective compliance and the lengthy time periods involved, it is
incumbent upon private company management to become familiar with the full
range of compliance initiatives under the Act; regularly review the company’s
short and long-term strategic plan; identify the potential compliance issues
applicable to its plans; determine which provisions to comply with and when to
phase them in; and revisit the determinations from time to time as the
company’s expectations materialize or its circumstances change.

Failure to adequately address these concerns in a timely
manner could delay or derail the realization of the company’s strategic plans
and, in the worst case, non-compliance could lead to significant liability.

Edward P. Gonzales is a partner in the Business Law Group
of Donovan Hatem LLP. He can be reached at [email protected].