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Corporate reform hits home: Is there still a place for private equity fund managers on public company boards?

The recently-enacted Sarbanes-Oxley Act of 2002 will have a substantial impact on the fiduciary duties of independent directors of public companies. Rufus C King of Testa, Hurwitz & Thibeault points out the problems inherent in the new burdens for fund managers considering whether or not to remain on the boards of companies they have helped to go public.

“Many are punished for the sins of the few.” This maxim applies to the corporate governance tsunami that is currently engulfing public companies in America. On the way to its summer recess, Congress passed the Sarbanes-Oxley Act of 2002 (the Sarbanes Act) and set in motion a chain of regulatory action by the SEC, the New York Stock Exchange (the NYSE) and Nasdaq that will be rolling out for many weeks and months to come. This one-size-fits-all statute, and the regulations that are being formulated to give it effect, will dramatically change the operations of all companies that are publicly traded in the U.S., whether domestic or foreign. The burden of compliance, however, will be particularly heavy on the smaller, growth-oriented companies that are typically financed by private equity funds.

The Sarbanes Act has changed what it means to be a director of a public company. Historically, many managers of private equity funds have chosen to remain on the boards of their portfolio companies after their IPOs. Fund managers make this choice, despite the risks involved (described below), in order to continue to monitor their investments and guide the companies through the difficult transition to becoming a public company. Now, however, the question for private equity fund managers is: will there still be a place for them on public company boards?

First, it is important to understand that the Sarbanes Act has not changed the basic duties and obligations of a director of a public company. Directors still have the same duties of care and loyalty to the company and its stockholders as they did before. What has changed is the emphasis on the role of independent directors in corporate governance. Moreover, the standard of independence is being re-set at an extremely high level. From now on, more active participation by independent directors in corporate governance will be required in several different ways.

Board Composition. Even before the Sarbanes Act, Nasdaq and the NYSE had proposed new rules that would require that a majority of the directors of each listed company be independent. In addition to excluding persons who are former auditors or relatives of a company's officers, among others, as not being independent, a Nasdaq proposal in July 2002 would have excluded as not independent any shareholder owning or controlling 20% or more of a company's voting stock. After enactment of the Sarbanes Act, however, Nasdaq revised this restriction to apply only to audit committee members (see below). The NYSE decided to avoid quantitative tests, for the most part, and instead requires that each board of a NYSE-listed company determine for itself that its independent directors meet the standard of having “no material relationship” with the company. As a footnote, the NYSE states that it “does not view the ownership of even a significant amount of stock, by itself, as a bar to an independence finding.”

Audit Committees. Under the Sarbanes Act, every public company must have an audit committee, each member of which must be independent. On the face of it, this goes no further than existing Nasdaq rules which require that every listed company have an audit committee, consisting of at least three independent directors. However, the Sarbanes Act sets forth a higher standard of independence than provided under either the existing or the proposed Nasdaq or NYSE rules. Under the Sarbanes Act, an audit committee member may not receive any consulting, advisory or other fees from the issuer, other than for service on the board or its committees. In addition, to be independent a director must not be an “affiliated person.”

The term “affiliated person” is not defined in the Sarbanes Act, and will no doubt be explained further in forthcoming SEC regulations. Nasdaq's proposed rules would exclude from the audit committee any person who owns or controls 20% or more of the company's voting securities, or such lower percentage as the SEC may determine under the Sarbanes Act. Apparently, an initial proposal would have set the limitation lower than 20%, but the National Venture Capital Association and other representatives of the private equity industry lobbied effectively to increase the proposed maximum ownership stake for independence to 20%. Nonetheless, many in the industry continue to believe that it is counter-productive to exclude representatives of the largest stockholders, including many private equity fund managers, from participation on audit committees, because these stockholders have the most at stake in ensuring that company management performs well and honestly.

It is not clear whether these SEC regulations will impose a higher or lower standard than the proposed Nasdaq 20% limitation on stock ownership. What is clear, however, is that by requiring an independent audit committee with specified duties, federal law will for the first time directly determine the composition and operation of public company boards of directors. Until the Sarbanes Act, these matters were governed solely by state corporate law and stock exchange rules.

Other Committees and Decisions. Independent directors are given other key roles in the new corporate governance model. Under Nasdaq's proposed rules, director nominations must be approved either by an independent nominating committee, or by a majority of the independent directors. In a nod toward corporate democracy, the proposed Nasdaq rules would permit a single non-independent director to serve on an independent nominating committee if that individual is an officer owning more than 20% of the company's stock. Other proposed Nasdaq rules would require independent director approval of executive compensation and related-party transactions. Independent directors would also be required to meet regularly in executive session without management and other non-independent directors. Clearly, the new corporate governance framework seeks to empower independent directors, but where are those independent directors to be found?

The Ongoing Risks. For private equity fund managers, the decision to stay on the board of a portfolio company after it has gone public has always involved weighing serious litigation risks and conflicting fiduciary duties, as well as limitations on the fund's ability to dispose of its holdings in the company. (See “Serving on Public Company Boards: When to Stay and When to Resign,” Venture Update, Summer 1994.) Now, the burdens of serving as an independent director on a public company board (if a fund manager is able to qualify as independent) have increased, while the litigation risks are probably greater. At the same time, director and officer (D&O) liability insurance is becoming much more expensive and is likely to provide less coverage. The dilemma for fund managers has never been more acute.

Conclusion. Two years ago a partner at a major West Coast law firm wrote enthusiastically about a new “Silicon Valley governance model.” In that model, a public company's investment bankers, lawyers, key customers and venture capital backers would be sought as directors for their “independent attitude,” rather than for their compliance with “some technical definition of independence.” Today, that antediluvian model of corporate governance for public companies has vanished, along with many of the other “new economy” conceits of the 1990s. This does not mean that there is no longer any place for private equity fund managers on public company boards. Venture capitalists and other fund managers will continue to play a vital role guiding their portfolio companies through the difficult process of going public and adjusting to the intense challenges facing newly public companies. However, fund managers and their portfolio companies that are public, or that aspire to go public, need to adjust rapidly to the new realities of corporate governance and work even harder to attract and retain good directors who meet the new, higher standards of independence.

Copyright © 2002 Testa, Hurwitz & Thibeault, LLP. All Rights Reserved

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