New Corporate Governance Requirements Under Sarbanes-oxley and the Stock Exchanges

• Jurisdiction: United States,Federal
• Citation: Vol. 32 No. 1 Pg. 13
• Pages: 13
• Publication year: 2003

32 Colo.Law. 13 Colorado Lawyer 2003.

2003, January, Pg. 13. New Corporate Governance Requirements Under Sarbanes-Oxley and the Stock Exchanges

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Vol. 32, No. 1, Pg. 13

The Colorado Lawyer
January 2003
Vol. 32, No. 1 [Page 13]

Articles

New Corporate Governance Requirements Under Sarbanes-Oxley and the Stock Exchanges
by Theresa Mehringer, Sean Stewart, Donna Bloomer

This article was written by Theresa Mehringer, a partner in Perkins Coie LLP, with the assistance of Sean Stewart and Donna Bloomer, associates at Perkins Coie LLP - (303) 291-2300. All three authors practice in the area of Corporate Finance

This article presents information on the current and proposed rules established by the stock exchanges and other trading markets in light of the Sarbanes-Oxley Act, which was enacted July 2002

During the months since the eruption of the Enron scandal in August 2001, there have been a plethora of responses and reforms regarding corporate governance from the Securities and Exchange Commission ("SEC"), stock exchanges and other self-regulatory organizations, as well as the U.S. Congress. The fact that the issue of corporate governance was a campaign issue in 2002 also has been noteworthy.

These reforms culminated in the adoption of the Sarbanes-Oxley Act ("Sarbanes- Oxley"),1 which became law on July 30, 2002. Following its enactment, the SEC and self-regulatory organizations have adopted or proposed many rules attempting to implement and interpret Sarbanes-Oxley. This article addresses generally how the corporate governance reforms made in the wake of Enron will apply to public companies, both large and small, and discusses some of the proposals made during the past year. This article is intended to assist practitioners in interpreting Sarbanes- Oxley in light of the current and proposed rules established by the stock exchanges and other trading markets.

CORPORATE GOVERNANCE

Corporate governance has become the latest buzzword in politics, law, and accounting. Generally, corporate governance refers to the rules a company must follow to take action on significant matters. Corporate governance is derived from and regulated by many sources, including the following:

the corporate law of the company's state of incorporation

a company's articles or certificate of incorporation and bylaws, plus any charter that might apply with respect to committees established by the board of directors

the federal securities laws and regulations promulgated thereunder by the SEC

the bylaws, rules, and any other interpretations of the National Association of Securities Dealers Automated Quotation System ("NASDAQ") or any stock exchange on which the company's securities are traded [for purposes of this article, this discussion is limited to rules issued by NASDAQ, the American Stock Exchange ("AMEX"), or the New York Stock Exchange ("NYSE") (collectively, "the Exchanges"), unless noted otherwise]

the rules of other regulatory agencies that have governing authority in certain industries (such as banking, investment advising, or insurance), although this article limits discussion to the first four sources of rules described above

In the past year, politicians have declared that the United States must have more stringent corporate governance standards to prevent debacles such as Enron and WorldCom and the accounting irregularities that surfaced. Sarbanes-Oxley was Congress's response to the irresponsible actions of a handful of large public companies, taking a one-size-fits-all approach to corporate governance. Unfortunately, Sarbanes-Oxley fails to take into consideration the interplay among the many other sources from which corporate governance is derived and under which corporate governance is regulated. In addition, it appears that Congress did not consider the effects Sarbanes-Oxley will have on small companies, and possibly privately held entities, that likely will bear significant burdens (as a percentage of revenues) to comply with the new requirements.

INTERPLAY BETWEEN THE EXCHANGES AND SEC

To understand how Sarbanes-Oxley provisions and the Exchanges' proposed changes in corporate governance will occur, a brief mention of the relationship between the Exchanges and the SEC is necessary. Any proposed changes to the listing requirements of the Exchanges must first be submitted to the SEC for comment and approval. Currently, the Exchanges have proposed changes that are pending with the SEC. Even before Sarbanes-Oxley, the Exchanges required more stringent corporate governance standards than had been required under the federal securities laws to ensure that the companies listed on the Exchanges had strong corporate governance procedures in place, creating a sense of security for investors.

Enron and Worldcom proved that there were gaping holes even in these more stringent qualitative standards set in place by the Exchanges. The Exchanges subsequently proposed rules not only to comply with Sarbanes-Oxley, but also to attempt to close these gaping holes so that only companies with the highest corporate governance standards can trade on the Exchanges. The chart on pages 16 and 17 sets forth in detail some of the more significant corporate governance provisions that have been enacted through Sarbanes-Oxley or proposed by the Exchanges.

SARBANES-OXLEY ONE-SIZE-FITS-ALL PROVISIONS

Sarbanes-Oxley, among other things, requires all public companies to have independent directors, audit committees, a code of ethics, internal controls, and disclosure procedures.2 However, many of the corporate governance rules now mandated by Sarbanes-Oxley for all companies were already in force in a targeted, more flexible manner under one or another set of rules or proposed rules. For example, prior to Sarbanes-Oxley, NASDAQ and AMEX had listing requirements with tailored exceptions to those rules for small or controlled corporations.3

Prior to Sarbanes-Oxley, the National Association of Securities Dealers ("NASD") proposed rules for implementing the Bulletin Board Exchange ("BBX"), a new exchange for small public companies. The BBX, if approved, will replace the Over-the-Counter Bulletin Board ("OTCBB"). The replacement of the OTCBB by the BBX is currently targeted to occur in the third quarter of 2003.4 The BBX website states that the BBX will provide a more structured trading environment, with the distinction of an exchange for small companies that choose to list with the BBX. The expressed intent of the BBX is to create a higher quality market, without mandating minimum share price, income, or asset requirements.5

The BBX had proposed listing requirements to tighten or enforce corporate governance policies while keeping in mind the capabilities and limitations of small public companies. However, the initially proposed rules for the BBX, which were tailored for the cost-effective protection of investors in small companies, did not meet the one-size-fits-all requirements of Sarbanes-Oxley.6 The BBX, as initially proposed, was intended to result in a trading market for smaller companies that could not afford the strict corporate governance standards of the Exchanges. However, as a result of Sarbanes-Oxley, the BBX has amended its proposed rules7 to comply with the strict corporate governance standards of Sarbanes-Oxely, which apply equally to all public companies, large and small.

In the new regime mandated by Sarbanes-Oxley, companies are no longer to be governed by rules specifically tailored to the problems in corporate governance particular to their size and capitalization. Instead, all public companies trading on the Exchanges are now subject to strict corporate governance requirements mandated by Congress under Sarbanes-Oxley to address problems particular to large public companies. Investors in small public companies are likely to receive little, if any, benefit from the additional regulatory burdens imposed by Sarbanes-Oxley.

PROCEDURES AND PROPOSALS

Some of the basic concepts of corporate governance are discussed in the following sections. Also covered are the proposals for implementing more stringent corporate governance standards.

Board of Directors and Committees

Under state corporate law, the board of directors is primarily responsible for corporate governance. The number of directors for a particular company often depends on its size. In smaller companies and privately held entities, corporate governance is usually carried out by a small number of directors who also are employees, executive officers, and/or significant shareholders. Prior to Sarbanes-Oxley, small companies usually approved any significant items by vote of a majority of the board of directors. In cases where some of the directors had an interest in the transaction, the company would have the disinterested directors approve the transaction, even though the disinterested directors were not necessarily "independent."

As a practical matter, it has been difficult for small public companies to find "outside," or non-employee, directors to serve on the board. Obstacles include the inability to pay directors' fees, the cost of obtaining directors' and officers' liability insurance, and the potential expense (despite the existence of insurance) in defending against shareholder suits. As described below, this problem is likely to be exacerbated by enactment of Sarbanes-Oxley provisions that require all public companies to have an audit committee consisting entirely of independent directors.8

Prior to Sarbanes-Oxley, there was no statutory definition of an independent director. Generally, a director who was also an employee, a significant shareholder, or...