“A manager who understands the new rules can be very helpful to his portfolio companies”

Mark Director of Kirkland Ellis discusses the implications of Sarbanes-Oxley for the private equity industry.

PEO: Is the private equity industry aware of how Sarbanes-Oxley will affect the way they do business?

MD: In general, the Sarbanes-Oxley Act applies to companies that have registered securities (debt, equity, or both) under the US securities laws. Most frequently private equity firms hold positions in “private companies,” which do not have registered securities. Consequently, private equity firms have been most focused on gathering information and gaining an understanding of how the legislation, and the regulations being adopted to implement the new law, may affect future decisions. Of course, a public offering of portfolio company securities is one of a number of popular liquidity options for the private equity investor. There are some private equity firms that invest regularly in public companies, while others may hold a handful of public company investments in their portfolios.  Consequently, Sarbanes-Oxley is relevant to the private equity business, and private equity firms need to (and generally are working to) understand its many implications. For those private equity firms that currently have seats on the boards of publicly traded portfolio companies or meaningful investments in public companies, the implications are most immediate, and in those cases, we have tended to see a greater sense of urgency.

PEO: How much attention should PE firms be paying to the new rules at this point?

To the extent a private equity firm has meaningful positions in a publicly traded company, or in a private company where a public offering is a realistic liquidity option in the near term, the firm should be devoting some real attention to the new rules. This is particularly true where a fund principal is serving as a director or senior officer of a publicly traded company – even on an interim basis. In these situations, the fund principal can have personal civil and criminal liability for non-compliance. Through the principal’s employment and indemnity arrangements with the private equity sponsor (and even a fund), the private equity firm itself – and quite possibly an individual fund – could be obligated to cover a principal’s legal costs and possibly any penalties or fines. Private equity firms, like public companies, should be reviewing their D&O liability insurance policies to ensure that any new obligations imposed by Sarbanes-Oxley are included within the scope of existing coverages.  Where there are questions or concerns, it is important to consult counsel and the insurer. 

More generally, because Sarbanes-Oxley creates important new obligations and potential liabilities for public companies, a private equity firm that has, or is considering, an investment in a public company should understand the various compliance and reporting obligations imposed by the new rules.  Much of the new legislation addresses corporate governance and transparency of financial reporting. These are critical issues for any investor, and a private equity firm should have a significant interest in ensuring that a publicly traded portfolio company is adhering to the rules and adopting the reforms required by the legislation. In addition, the coming reforms to be implemented through revised stock exchange listing standards (for the NYSE, the NASDAQ, and the AMEX) will add to the thicket of requirements imposed on publicly traded companies. A failure to comply with the new rules not only can have dire consequences for an issuer – such as penalties and even the loss of eligibility to be listed on an exchange, but also can deprive the private equity investor (and other investors) of the benefits of enhanced governance and reporting. Among other things, in the current market environment, a company that ignores the new rules or implements them haphazardly is likely to see itself being criticized and the price of its securities being pressured. 

A private equity firm that understands and has thought about the new rules can be very helpful to its public portfolio companies. Given the imbalance between a portfolio company’s resources and the demands imposed on its time and capital simply to execute its business plan, a private equity sponsor can help a portfolio company cope with the implementation of the new rules. A private equity firm can leverage its knowledge across all of its public investments. It can help a portfolio company about to go public or only recently registered design and implement appropriate corporate governance guidelines and establish a suitable regimen for financial reporting, auditing, and control activities that comply with the new rules.

PEO: How is the private equity transaction process going to be impacted?

We will see the largest impact on the relationship between private equity firms and their portfolio companies that either have, or are about to have, registered securities (because these are the companies that are subject to the new rules). A private equity firm considering a PIPE (private investment in public equity) transaction will want to understand whether the intended target is in compliance with the new rules, or what changes it will need to make to come into compliance. If the investment is particularly significant and the private equity firm will have a board seat, the firm will have to understand how the new rules affect its involvement on the board and the responsibilities of its designee.

When a private equity sponsor takes a portfolio company public, it likely will retain an interest (and potentially a significant interest) for a period of time after the public offering. In this situation, as well as the one noted above, it may retain board representation. Because of the increased responsibilities being placed on directors generally, and on members of certain committees specifically (especially the Audit Committee), under the new rules, private equity firm principals will need to give careful thought to the roles they are willing to play on board of directors and how many portfolio company boards they can join responsibly. In addition (although this still needs clarification from the SEC), where a private equity fund holds a large ownership position in a public company, the fund's designees on the Board may or may not be considered “independent” directors. If the designees are not independent, they will not be able to serve on the audit committee or be involved with other decisions, such as CEO compensation.

PEO: Which types of transactions are going to be harder to complete?

Portfolio companies and their private equity sponsors will need to plan even more carefully before making the decision to have the portfolio company register any securities for trading on the public markets. Private equity firms also will have much more to consider when evaluating a significant investment in a company that already has public securities. The new rules should not in any way deter transactions that make economic sense, but they do make the task of being a public company more complex and they demand even more from senior officers and from directors of public companies.

Private equity firms also will need to consider how to deal with certain fairly common business arrangements, such as loans to insiders, that the law now prohibits once a company has publicly registered securities. Sarbanes-Oxley prohibits a “covered issuer” from extending or maintaining credit to any executive officer or director (directly or indirectly) in the form of a loan, except in certain fairly narrow circumstances. The term 'loan' was not defined in the new law, and the SEC has not yet issued any rules to provide guidance on these issues. The private equity industry needs to be especially aware of this provision where it is working with a portfolio company that has, or is soon expected to have, publicly registered securities. In such circumstances, the new law will affect the way in which the private equity firm might otherwise have sought to assist senior management in gaining an ownership stake in their company.

PEO: What has the SEC done so far in terms of issuing relevant guidelines to the market?

The SEC guidance so far has related directly to public companies and includes accelerated reporting of insider transactions, accelerated filing requirements for periodic disclosure reports, and the details of certain certifications that CEOs and CFOs are required to file together with their companies’ periodic disclosure reports. In mid-October, the SEC proposed the next set of implementing rules, regarding disclosure of information about internal control reports, company codes of ethics and the inclusion of “financial experts” on Audit Committees. The SEC also proposed rules addressing prohibitions on actions taken to improperly influence a company’s outside auditors. The SEC timetable is fixed by Sarbanes-Oxley, so we should expect to see additional guidance over the next several months.  The SEC is scheduled to consider proposing additional new rules to implement various aspects of Sarbanes-Oxley at its meetings at the end of October.  This level of activity is likely to continue into next year.

In addition, both the New York Stock Exchange and the NASDAQ Market have submitted a range of governance proposals that are expected to be adopted after they go through a public notice and comment period at the SEC. (The exchanges are required by law to  submit proposals  to the SEC for review, public comment and SEC consideration before they become active  “rules,” even though once adopted they are “rules” of the specific exchanges.) The exchanges also are expected to adopt (and then submit to the SEC) additional proposals responsive to various aspects of Sarbanes-Oxley that, by law, are to be implemented through new or amended exchange listing requirements.  Under the exchanges’ current proposals, listed companies would be required to adopt general codes of conduct addressing issues such as conflicts of interest and compliance with laws. Both exchanges also are proposing that a majority of a listed company’s board of directors be comprised of “independent” members, although the NYSE and the NASDAQ have advocated different definitions of “independence.” Both exchanges also have proposed that independent directors assume responsibility for director nominations and CEO compensation.

It is fair to say that at this stage, there is still a significant amount of uncertainty, and a substantial number of unresolved questions, surrounding many of the provisions of the new law.  The SEC’s rules are beginning to address and clarify some of these issues, but the SEC has not offered guidance, either formally or informally, on many subjects.

Mark Director is a corporate partner in the Washington office of international law firm Kirkland & Ellis. He can be reached at mark_director@dc.kirkland.com