SARBANES-OXLEY: Pushing Small Public Companies Out of the Public Arena?

by Robin V. Foster

Directors and executives of smaller public companies (particularly those with less than $500 million in market capitalization) are asking whether the attendant costs and liability exposure outweigh the benefits of being a public company. These questions have focused discussion in recent years on what has become labeled the "orphan" public company. Such orphans are characterized by low market capitalization, lack of interest on the part of institutional investors, lack of coverage by analysts, and low trading volume resulting in a lack of liquidity. And now, the Sarbanes-Oxley Act, enacted last Summer, has increased the costs and liability exposure for all public companies, big and small.

Companies sell their stock to the public for several reasons, including to gain better access to capital markets, and to have available a second currency--their own securities--for acquisitions and other purposes. Large, public corporations routinely tap the equity and debt markets to fund their capital needs for growth. Public companies with low market capitalization, however, often find that their access to the capital markets may be no greater in reality than the access they could have as privately owned businesses.

Taking advantage of the benefits of being public comes at a price--regulation by the SEC and exchanges such as the New York Stock Exchange. Public companies are required by law to report quarterly and annually a broad range of business and financial information. In addition, public companies must report certain material developments on a current basis. The costs of compliance with these requirements are substantial, and increasing. Sensational stories concerning Enron, WorldCom, and other highly visible companies led the Congress to enact Sarbanes-Oxley, which in turn has spawned a raft of new regulations applicable to public companies. Liability exposure of public company directors and executives also has increased. Under Sarbanes-Oxley, senior executive and financial officers now must individually certify their companies' period SEC reports. False certifications carry substantial criminal penalties.

In many cases, faced with the substantial costs and liability of being public and the lack of any real benefit, small orphan companies are "going private"--initiating transactions that result in the purchase of the shares held by the public."Going private" generally connotes a transaction that is structured to leave the orphan as an independent company, albeit privately owned, in contrast to transactions in which another company simply acquires the small public company.

A major challenge in going private is finding the source of cash to buy out the public shareholders. The current deflated stock market may create opportunities to go private at more realistic (and bankable) valuation levels. In many cases, the use of a leveraged ESOP may be a viable alter-native (with potentially significant tax advantages). Assuming the funding is in place, the process for going private is well defined. The board of directors almost always establishes a committee of independent directors to represent the interests of the public shareholders. The committee hires its own legal counsel and investment advisors and may have to consider offers from other potential buyers.

Ultimately the independent committee may recommend to the public share- holders to accept or reject an offer to buy their shares. In some cases, independent committees choose not to make a recommendation.Generally, state laws permit purchaser who acquires a larger majority of the stock (typically, 90 percent) to force out the remaining shareholders. Small public company boards and executives should not, however, assume that going private is the right answer in all cases. Rather, it is an option to be considered in light of all factors, including potential debt burden of acquisition of public shares, and other factors unique to each company. Before a small public company chooses to go private, the board of directors must carefully weigh the benefits and burdens of remaining public versus going private.

Robin V. Foster is a partner at Blackwell Sanders Peper Martin, LLP. He can be reached at 816.983.8145 or by e-mail at rfoster@blackwellsanders.com