Private Drive
Form meant as much as substance in 2002 when Congress enacted the Sarbanes-Oxley Act as the main weapon in the fight to wipe out corporate corruption and restore faith in the stock markets.
When that substance started weighing heavily on smaller publicly traded companies, some corporate lawyers began to wonder whether these companies would be driven from markets altogether. They argued that going private would remove public companies from the act’s expansive reach and from demands imposed by other securities laws. But the market exodus some predicted in the law’s immediate wake never took off.
In 2005, though, the costs of Sarbanes-Oxley compliance likely will continue to rise as the law phases in more elaborate safeguards to keep companies honest. Some transactional lawyers say they wouldn’t be surprised if the new requirements spur more companies to duck out by going private, resulting in a corporate landscape dominated by the richest companies.
“This Sarbanes-Oxley Act is regulation on a scale like we’ve never seen before,” says M&A specialist Nathaniel L. Doliner in the Tampa, Fla., office of Carlton Fields. “Certainly there need to be some changes in Sarbanes-Oxley. You want small companies to retain the ability to remain public.”
Going private deals can take on many forms, but they all primarily aim to remove public companies from the province of government regulators like the Securities and Exchange Commission, or stand-alone private watchdogs like stock exchanges.
The most common approaches use varying versions of tender offers, where the companies try to buy back their outstanding shares, and mergers, where a private company acquires a publicly traded one. Under certain conditions, some companies with fewer than 300 shareholders of record—nearly always banks and brokerages that trade in large blocs—can walk away from SEC and private regulation simply by “deregistering” with the agency and “delisting” with the exchanges by withdrawing their securities from trading.
Sarbanes-Oxley, however, accounts for just one possible motive for going private. Market trends and general economic conditions also come into play. Lack of analyst coverage and depressed share prices can provide powerful incentives. And as the people’s willingness to invest in certain risky ventures wanes, more private lenders are stepping forward to fill the void.
But going private can be fraught with peril because it entails navigating mazes of federal, state and private regulations. Because going private often involves purchases of stock by directors and other insiders that could harm shareholders, courts painstakingly scrutinize such transactions for evidence of self-dealing.
Nevertheless, the number of companies going private did increase the year after Sarbanes-Oxley passed. In 2003, 80 companies went private in deals valued at $8.7 billion in all—up from 48 in 2001 with a total value of $5.8 billion, according to research by Thomson Financial. Still, a look at 2004 suggests that if going private is a movement, it’s proceeding at a glacial pace, with just 37 deals valued at $31 billion announced from January through October. (Of that, Thomson attributes $8.4 billion to a single going-private plan involving radio and television station owner Cox Communications Inc.)
A Waiting Game
Still, transactional lawyers are waiting for a second Sarbanes-Oxley shoe to drop. If and when it does, they expect it to land hardest on smaller businesses.
Shortly after the law passed, some more optimistic observers predicted that compliance costs would be modest, one shot affairs as companies adopted ethics codes and set the machinery in motion for executive certification of their financial statements. But it turns out that the law promises continued and staggering increases in the cost of remaining on the public trading floor.
In a survey released in mid-2004, the Milwaukee-based law firm of Foley & Lardner found that 85 responding smaller companies—those with annual revenues of less than $1 billion—saw the cost of remaining public rise by 130 percent, from an average of $1.2 million in the budget year before Sarbanes Oxley to an estimated $2.8 million in their 2003 budget years.
Why the increase? Due to the greater personal civil and criminal responsibility the law places on executives, premiums more than tripled for directors and officers insurance, as did pay for board members. Legal and accounting costs also increased.
That was nothing: The expenses are expected to increase even more dramatically over this year as companies begin implementing a portion of the act called Section 404. The provision goes well beyond the certification requirements already in place, forcing companies to regularly conduct extensive audits of their internal financial control systems and identify any “material weaknesses”—a term the SEC did not define when it issued the regulations to enforce Sarbanes-Oxley.
In the Foley survey, 63 percent of the respondents cited 404 compliance as their No. 1 cost. The survey also found that 21 percent were considering going private because of the new corporate governance and disclosure regime ushered in by Sarbanes-Oxley. In a similar survey in 2003, only 13 percent of the participating companies indicated they were considering the private route.
Going private isn’t cheap. A company can expect to incur up to $2 million in expenses. But these one time costs may be especially attractive to companies with $100 million or less in revenues that otherwise would keep pouring money down the Sarbanes-Oxley black hole.
“I think there will be a number of companies going private,” says Thomas E. Hartman, a Foley partner in Washington, D.C., who conducted the survey.
“Those companies are going to have to figure out a way to get this problem straightened out,” he says.
Larger companies began working on 404 compliance last year, while smaller ones face a July 2005 deadline. The SEC has slightly extended the cut-off date for some, but its core attitude appears inflexible. As one high ranking agency lawyer put it: “The whole idea of Sarbanes-Oxley is to get the numbers right. If you’re not going to take the steps to get the numbers right, you’re not going to be a public company.”
Comments like that, plus timing, could speed the drive to the private arena. That’s because the 404 deadline looms as companies already are hip-deep in preparing their annual reports and meeting materials. Talk about having a lot of balls in the air.
“It’s very difficult to see how a small business with a limited number of employees will be able to do that,” says Richard A. Denmon, who leads Carlton Fields’ securities practice group from Tampa. “They will have to go private sooner rather than later to get out of 404 compliance.”
