Sarbanes-Oxley: Coming Soon to Your Family Business!

September 17, 2004

Sarbanes-Oxley.  n.  1.  Landmark U.S. legislation striking fear in public company directors, CEOs and CFOs.  2. Unrelated Congressmen, virtually unknown to the average business owner prior to July 2002, now part of the American corporate lexicon known to all.  adj. expensive, burdensome, overreaching.  Synonym. Corporate governance.


The Sarbanes-Oxley Act of 2002 (“SOX”) ushered in the most sweeping corporate governance reforms and changes to the federal securities law in over 70 years.  Immediately following the enactment of SOX on July 30, 2002, public companies began to adopt and implement numerous policies and procedures to comply with SOX and its progeny of regulations, rules and stock exchange listing standards.  In response to widely publicized corporate scandals that occurred at some of the largest and best known public companies, SOX has forced public companies to: maintain greater independence from their outside auditors; continuously improve and monitor their accounting and disclosure controls; create board committees comprised entirely of independent directors to oversee the company’s audit, compensation, corporate governance and nominating functions; establish and enforce corporate codes of conduct and ethics;  prohibit loans and other financial perks for executive officers; and the list goes on.  These measures have come at a significant cost to public companies, both in direct out-of-pocket expenses and the enormous amounts of time devoted by their boards of directors, executive officers and employees to ensure compliance with SOX, all in the name of preventing corporate fraud and misconduct.

You might be thinking “Whew! What a relief! My company is a privately-owned, family business.  Sarbanes-Oxley doesn’t affect me at all.”  If so, you may be in for a big surprise.  While the vast majority of the media attention and reaction of Corporate America to SOX has focused on public companies, and rightly so, certain provisions of SOX apply to all companies.   Privately-owned companies like your own do not have a blanket exemption, regardless of how few shareholders you may have.  Perhaps even more importantly, sooner or later, the indirect effects of SOX will likely have significant consequences to your family business.

SOX Provisions that Directly Apply to Privately-Owned Businesses.  While most  of the new laws created by SOX are aimed exclusively at publicly-owned companies, the following provisions are applicable to all businesses. 

  • SOX creates significant new penalties for any person who retaliates against, or takes any action harmful to, an individual who provides truthful information to a law enforcement officer relating to the commission or possible commission of any violation of federal law (i.e. a whistleblower).  Retaliating or taking other action detrimental to the whistleblower can result in monetary fines and/or imprisonment for up to 10 years.  Private companies should establish clear policies that protect whistleblowers and that put all employees on notice that retaliation in any form will not be tolerated.
  • SOX imposes monetary fines and/or imprisonment for up to 20 years upon any person who destroys, alters, conceals or falsifies any record, documents or other tangible object with the intent to impede, obstruct or influence the investigation of any matter within the jurisdiction of a federal agency or department.  Like public companies, private businesses should consider adopting appropriate document retention policies and procedures and educating employees on these issues, to minimize the likelihood of improper document destruction.
  • Administrators of all 401(k) plans, pension plans and other ERISA plans must notify plan participants and beneficiaries at least 30 days in advance of any blackout period (i.e. any time period of more than three business days when participants will not be able to diversify assets in the plan or to take distributions or loans from the plan).  Failure to provide the required notice can subject the plan administrators to fines of up to $100 per participant per day.
  • SOX extends the statute of limitations for securities fraud lawsuits to the earlier of two years after the discovery of the facts causing a violation or five years after the violation, regardless of when or if the violation is discovered.  This applies to private companies when they engage in any offering of securities, notwithstanding that such offerings may be undertaken pursuant to an exemption from the registration provisions of the securities laws.  In addition, debts resulting from a violation of any federal or state securities laws or regulations or from common law fraud in connection with the purchase or sale of any security are no longer dischargeable in bankruptcy proceedings.
  • SOX also created new criminal fraud offenses and increases criminal penalties for mail and wire fraud.

Indirect Consequences of SOX on Privately-Owned Businesses.  While the above described SOX provisions could have a very significant impact on your family business, the potential indirect consequences of SOX may be even more likely to affect the way you do business going forward.  The most compelling reasons why privately-owned companies need to take notice of SOX fall into three major categories:  Financing, Exit Strategy and Personal Liability.

Financing.  At some point in the life of your family business, it will need outside financing.  You may need more money to get your business started, to make key capital expenditures, to grow your business through acquisitions or for a myriad of other reasons.  Once you’ve exhausted or exceeded your own funds and that of supportive family members and friends, you will look to third party sources such as banks, insurance companies, venture capital firms, angel investors, mezzanine investors, strategic partners and private equity firms.

Regardless of which source(s) may fit your financing needs, all of those sources have a common objective of wanting to ultimately recoup their investment plus an attractive return.  Increasingly, we are seeing that financing sources are focusing on accounting controls and corporate governance measures as part of their due diligence prior to making their final investment decision.  Private companies must be able to demonstrate that its financial statements are accurate, that its accounting systems and controls are reliable and capable of preventing fraud, that its auditor is independent and that transactions with insiders are either non-existent or have been conducted at arms’ length and approved by disinterested directors.  The representations, warranties and covenants required in the financing documents are now addressing SOX-like issues for private companies, notwithstanding that many of those requirements are not mandatory.  All of these measures are hallmarks of the corporate governance initiatives engendered by SOX and your private company will either need to have those in place when seeking money or be prepared to make changes to your ways of doing business as a condition of obtaining these all important funds to fuel your business for the current and next generations.

Exit Strategy.  Many family businesses desire that the business be perpetuated from generation to generation.  The reality is that many family businesses do not even transfer to the second generation, let alone the third or fourth generations.  If at some point you find that there are no successors who are able or want to continue the business, you will want to develop an exit strategy to allow you to reap the financial benefits of the capital and sweat equity invested by your family in the business over the years.  Even if the next generation is ready to continue the business, you may want to at least explore alternative exit strategies to know what your business is worth and/or to be prepared for the unexpected loss of a key family member.

Possible exit strategies would include a complete sale of your company, a merger with a larger company or an initial public offering.  As with potential financing sources, all of these alternatives will involve third parties closely scrutinizing your business and its operating practices.  No one will be willing to pay full value for your company unless they are completely comfortable that the business has been well run, that the numbers are valid and that the owners, management and employees of your company have conducted themselves with integrity.  You should also expect that you will be required to make comprehensive representations and warranties about these matters and that you will have an obligation to indemnify the purchasers for any breaches.

If you are contemplating going public through an IPO, the SOX requirements become applicable to your company in full upon the filing of your registration statement with the Securities and Exchange Commission – before you even begin to approach investors, let alone have any offering proceeds in hand.  Investment bankers and potential investors will want to know that the company is SOX compliant from day one, the risk of non-compliance simply being too great.  The net result is that advance planning for an IPO must begin in earnest at least six months prior to the initial filing of the registration statement, and possibly even earlier.  Designing and implementing appropriate accounting controls takes substantial time and effort, and simply cannot be accomplished in a satisfactory manner on the eve of an initial public offering.

Personal Liability.  As mentioned above, SOX substantially increased the possible penalties for a variety of actions that may subject privately-owned companies and their directors and officers to severe consequences.  People go to jail, not corporations.  Fortunately, the likelihood of going to jail is only a remote possibility for most family business owners, absent egregious misconduct or fraud.  However, the potential for increased civil liability in private lawsuits is a real threat that should not be overlooked or ignored.

SOX has raised the bar for the appropriate standards that directors and officers of privately-owned companies must follow.  All family businesses have at least one shareholder or owner.  Many family businesses have multiple shareholders that may include non-immediate family members or perhaps a fairly large number of employee shareholders.  Regardless of the number, directors and officers owe fiduciary duties to those shareholders.  State corporation laws do not distinguish between public and private companies and the standards of care and loyalty are the same across the board.  The best practices that are emerging in public companies in today’s post-SOX environment are expected to become the new standards that courts and juries will look to when considering whether a private company’s directors or officers fulfilled their fiduciary duties.  No logical reason would explain why a shareholder of a private company is harmed any less than a public company shareholder if a CEO’s fraud or other misconduct causes the value of a shareholder’s investment to decline or become worthless.

The ever increasing risk of personal liability also has a direct effect on the ability of a private company to attract and retain qualified independent directors to serve on its board of directors.  Many family businesses benefit greatly from the knowledge, skills and experiences that outside directors bring to a board.  Typically, these outside directors are willing to lend their expertise to privately-owned companies because of a desire to mentor others or because of personal relationships with the insiders.  But now, with the increased awareness of potential liability, qualified outsiders will be more reluctant to join a board or continue board service, unless convinced that the liability risk is minimal.  Outside directors are also demanding that private companies have adequate directors and officers liability insurance in place as a condition of joining a board, which insurance cannot be obtained in many cases unless the insurer is satisfied that adequate SOX-like controls are in effect at the private company.

Your Reputation and Good Name.  If you’re still skeptical about how SOX will affect your family business, please consider one more point.  Your family business is inextricably linked to the reputation and good name of your family.  Your customers, vendors, employees and the community in general all expect that the companies with whom they do business possess integrity, honesty and good business practices.  Adopting good governance practices can help you attract and retain employees and customers and embellish your reputation as a solid business.  Simply put, it’s good for your business!  On the flip side, it’s safe to say that you don’t want the name of your company to join the growing list of companies that have been toppled in spectacular fashion at least in part due to corporate governance problems – Enron, WorldCom, Adelphia, just to name a few!

Actions to Consider.  The good news is that privately-owned companies have a choice, unlike public companies that have been mandated to implement the entire slew of corporate governance reforms in a very short period of time.  A private company has the ability to analyze which measures make the most sense for its unique circumstances and to implement those measures in stages in order to get the most bang for the dollar. 

Some measures are relatively inexpensive to implement, but can have very positive and quick results.  You may want to consider adopting a corporate code of ethics for all employees, which sets the tone for the entire organization and demonstrates to employees that values count; or devising a confidential system which would allow employees to anonymously report suspicious activities, thereby enabling management to detect problems at an early stage; or inviting qualified, independent persons to join your company’s board of directors, listening to their candid advice and empowering them by establishing independent board committees having true oversight of the company’s audit and any related party transactions.  Other measures may be more costly, but well worth it in the longer term.  In this vein, you may want to explore engaging an independent, reputable accounting firm to audit your company’s financial statements; or establishing stronger accounting systems and controls to ensure that your company’s results are being accurately measured.

Regardless of what the appropriate actions might be for your particular family business, the important thing is to be aware that the requirements and expectations for all businesses continue to change.  Like it or not, Sarbanes-Oxley is coming soon to your business.  Be prepared!


Reprinted with permission from The Cincinnati Business Courier, September 17, 2004