The Impact of Sarbanes-Oxley on Private Companies
an interview with Philip Peters of Thelen Reid & Priest LLP
John Dalton | University of California, Davis, School of Law
Bandana K. Kohli
Posted Monday, December 4, 2006
7 U.C. Davis Bus. L.J. 11 (2006)

Mr. Peters is a Partner at Thelen, Reid & Priest in San Francisco. He graduated from UC Berkeley, Boalt School of Law in 1986 and began working with the firm immediately after graduation. Mr. Peters' practice focuses on the purchase, sale, financing, and reorganization of business enterprises and assets, across a variety of industries, in both domestic and international transactions. He is an expert on pre-merger approvals under the antitrust laws. He has also been involved in the formation of domestic and international joint ventures in the power and energy industries and has experience in a wide range of commercial, project finance and real estate transactions.

The enactment of the Sarbanes-Oxley Act ("SOX") in 2002 directly affected the practice of corporate law. SOX , a sweeping reform, covers the governance of public corporations and their disclosures. The law is expansive in its scope and reach. It established the Public Company Accounting Oversight Board ("PCAOB"), provided for pervasive regulation of the accounting profession, created a framework for major reforms in corporate governance, required enhanced and more timely disclosures by public companies, mandated significantly increased criminal penalties for violations of the federal securities laws, prohibited senior officers and directors from trading in company securities during benefit plan black-out periods, and incorporated "whistle-blower" protection provisions for employees identifying and reporting securities law and other violations. There has been substantial regulatory activity implementing SOX during the four years since it was enacted.

Mr. Peters has published several articles and spoken about the impact of SOX on private companies and the business world in general. His articles have included "How to Manage the Corporate Governance Risks of Large, Privately Held Companies," which focused on non-public entities and corporate governance compliance.[1] He spends much of his time counseling complex enterprises on how to contend with evolving corporate norms.

Q: Why is SOX even relevant to non-public companies? Can you explain the impact SOX has had on private companies?

A: The crisis in confidence that gave rise to SOX is at first glance of questionable relevance to private companies. By its terms, the reform laws apply mainly to reporting (i.e., public) companies. The ongoing reforms and responses by participants in the financial world have impacted the way all business is conducted in this country. In a general sense, it is fair to say that the standards of care within all corporations, public and private, are changing and will continue to change, in the aftermath of the major scandals we have seen recently in the corporate world. It is clear that the conduct and expectations of lenders, accountants, insurers, government contracting parties, and shareholders is being influenced by the ongoing reforms. Private companies need to review and make changes in their corporate governance structure and practices, their system of internal controls, their approach to financial reporting, and their corporate culture regarding appropriate behavior. We receive many requests for SOX-based advice from complex private companies that have both management and non-management shareholders (i.e., insiders and outsiders).

Q: What is fundamentally the most important part of SOX and related regulations?

A: The underlying premise of SOX is that boards of directors were not doing their jobs properly. The legislation was an effort to require them to do so. In laymen's terms, SOX is an effort to require boards of directors to exercise their oversight function in a much more vigilant fashion. Boards can no longer blindly accept what management is doing without further inquiry. Outside directors and an independent audit committee are now required.

Q: Is the behavior within large companies changing?

A: In general, yes, it has changed. Some may cite the recent backdating and pre-texting scandals to argue that corporate behavior and culture have not changed enough. It is clear that companies need to examine more closely those practices and transactions which are obviously close to the line. Yet, many companies seem to be driven by what they perceive as competitive pressures: "Hey, they are doing it, we should too!" This, obviously, has proven to be a short sighted approach.

Let us go back to the Enron and AIG scandals. Both scandals were about transactions that had no business purpose. They were entered into for accounting purposes, to make the balance sheet look better. Those transactions were not clearly illegal. Perhaps some were, but there is a fair argument that these transactions were within the letter, if not the spirit, of the law. Now, fast forward to the current pre-texting scandal. Again, it is not absolutely clear that what HP was doing was illegal. They were likely told that the law is not clear and it is probably safe. But the boards of directors need to step back and take a harder look: everyone knows it is wrong to pretend you are somebody else. It may not be expressly illegal, but it is certainly wrong. Some companies still are not looking hard enough into matters that are close to the line. If you are on the Board, then you need to work very hard to understand and address these situations. This is the lesson for any complex organization, whether public or private: if they are doing something that is close to the line or unethical, they are going to get hurt.

A key theme underlying SOX is the "tone at the top" notion, meaning that the senior management is responsible for the culture they create. The CEO is ultimately responsible for the integrity of the company's disclosure controls and financial reporter. Senior officers must be faithful to the same rules they set out for employees. The effects of a failure to set the right tone at the highest levels of an organization are obvious. A cavalier attitude toward accounting and disclosure cropped up in our business society. In retrospect, the failures seem so pervasive that it can only have resulted from a total lapse of corporate ethics. Even if senior managers did not knowingly participate, their failure to be aware of and prevent an environment in which far-reaching scandal was possible was at minimum a serious moral failure. Thus, there is a new emphasis on the duty of senior officers to set the ethical tone within an organization.

As a result, we are seeing more and more companies where the boards are insisting on full performance of their oversight functions, adopting codes of ethics, seeking to understand what management is doing, appointing independent directors, etc. But the world is not a perfect place and competitive pressures can trigger questionable conduct. The good news is that companies are changing and looking closely at matters of ethics. Management must seek to instill an appropriate "tone at the top."

Q: How do you explain the recent backdating scandals?

A: Blaming these scandals on corporate greed or the greed of the option recipients is an oversimplification. Backdating was an attempt by top management (not the board of directors) to recruit middle and senior managers. They sought to do it by granting them "in-the-money" options, which are valuable to the recipient, but which do not give rise to the adverse earnings impact of paying out cash. The top managers responsible for these grants may not have been acting out of greed for themselves, they may have been seeking what they perceived to be what is best for the company, i.e., to attract and retain talented managers in a competitive environment. They may have felt the company would be at a competitive disadvantage if they do not do it, especially if they perceived competitiors doing the same thing. Thus, the basic purpose of SOX remains on point: boards of directors need to watch senior management and closely examine actions which are close to legal limits.If the board does not properly discharge its oversight responsibility, someone is going to get punished.

Q: Are there certain companies or industries that have been disproportionately impacted by SOX and related reforms?

A: The impacts have not been disproportionate across industries, to my knowledge, but the impacts clearly are more severe on smaller companies. The financial impact of compliance with SOX depends on the Company's governance prior to the reforms. Larger companies may have had major expenses in complying with internal controls, but the financial impact may have been slight compared to overall revenues. Many smaller public companies, however, may not have had outside directors, experienced accounting experts, comprehensive ethics policies and the like prior to enactment of SOX. These companies absorbed a relatively greater burden in complying with the new rules. In addition, the costs of outside accounting services have increased. Accountants are subject to a new set of rules and have a higher standard of care. Their clients are paying for that.

Q: Is it reasonable to expect that private companies will some day become bound to comply with SOX?

A: No, it is doubtful that SOX will ever directly apply to private companies. Keep in mind, however, that we are undergoing a sea change in terms of the expectations of all players in the financial markets. Think about the fundamentals. In terms of state corporate law and principles of fiduciary duty, there is no fundamental distinction between publicly-held and privately-owned companies. While there has not yet been a wave of new state legislation, we have seen some. In California, we have seen the California Corporate Disclosure Act and SOX-based reform laws applicable to charitable corporations. As state corporate laws are amended in response to recent scandals, the standards for corporate decision-making will change. The scope of the business judgment rule will be modified and perhaps be narrowed under judicial interpretation. The point is that the new principles are in the air: SOX has promulgated new standards that will inevitably seep into state law.

Q: Does SOX impact private companies' ability and/or desire to go public? If so, how?

A: There is no doubt that SOX does add some incremental costs to becoming a public company. Whether it affects a company's decision of whether to go public, who knows. If the need for capital is great, my guess is that a private company is not going to care. If you need $100 million to execute your business plan and those funds are not available privately, are you going to go public or fold up the tent on a viable plan? Some have said that the recent activity of private equity funds is facilitated by an adverse reaction to SOX that encourages going or remaining private. I personally doubt that. If that were true, the costs of SOX compliance would be a small tail wagging a rather large economic dog.

Q: Where do you see SOX going in the future? Do you see amendments giving it greater bite or do you expect a repeal of some sort?

A: I think SOX is here to stay. It is a backbone. It provides bedrock principles that are being assimilated by state legislatures, regulators, lenders, insurers and others. I certainly do not expect it to be repealed or softened. We are still seeing certain scandals. However, we are now seeing actions by regulatory agencies that seek to tweak the rules in certain ways. For example, the SEC is scaling back the internal control rules that have proven to be unreasonably burdensome on auditors, at the same time, it is enacting new disclosure requirements on related party transactions and executive compensation.

Q: For public companies there is a PCAOB. Is there any similar board for private companies under SOX?

A: That is a really good final question that sums up some of the themes of this interview. The answer is no, there is no board like PCAOB that exists for accountants of private companies. But do not stop your analysis there. Accountants that are registered with the PCAOB are going to find it very difficult to apply different standards. The standard of care is different now for the accounting profession generally. Private companies will have the benefits and burdens of their accountants' registrations with PCAOB. There will be more quality control, the costs may go up, but you will have more reliable accountants across the board. As I have said, the business world has changed in the aftermath of the corporate scandals and the enactment of SOX.

[1] Philip Peters, How to Manage the Corporate Governane Risks of Large, Privately Held Companies, Construction Weblinks, October 7, 2002, available at

John Dalton is a 1L at UC Davis School of Law. Bandana Kohli is a 2L at UC Davis School of Law.