Tuesday, February 27, 2024

Corporate Governance in Private Organizations


In the wake of corporate scandal, widespread unethical behavior, and illegal activity in some of our most respected organizations, corporate governance in both public and private organizations is undergoing possibly the greatest change since the original creation of the Securities and Exchange Commission during the 1930s.

The Sarbanes-Oxley Act of 2002 formalized many new white-collar crimes¹, set stiff penalties² for such crimes, and is impacting every element of Board governance from independent membership and financial competency, to employee whistleblowing and the role of auditors.

As a result of Sarbanes-Oxley, and other regulatory changes driven by the SEC, NASDAQ, and the NYSE, new standards of corporate governance, while only required by law at public companies, are forming the “best practices” of enterprise governance for both private companies and non-profit organizations as well.

Increasingly, private enterprises, especially those with employee owners, need to ground their organizations upon the new solid foundations of fiscal and management responsibility to avoid problems that could interfere with their future. These private companies need to adopt “best practices” and transparency to ensure private investors, employee owners, workers, and their society of their integrity, as well as to suit themselves for possible or eventual IPOs, mergers, or acquisition by a public company.

While the various new rules and regulations are extensive, some of the most important new practices that apply to private Boards and enterprise governance require: new and significant levels of director independence, directors that have financial knowledge, increased work and due diligence on the part of directors, establishing written guidelines and Codes of Ethics, and in some cases, that directors conduct performance appraisals of the CEO and a self-appraisal of themselves.

1) Independent Directors

Possibly the most significant changes for many small and private enterprises is the new requirement for public Boards to be composed of a majority of independent and non-employee directors. This is a significant change for small organizations which often tap executive management, friends, or family for Board membership and often include no independent membership whatsoever. At a minimum, Board members should contribute value to the company that goes beyond that already provided by executive management and employees, and the requirement for independence should be fulfilled by knowledgeable individuals who are free of the conflicts of interest experienced by family and friends.

In particular, Sarbanes-Oxley requires that all members of the Audit Committee be independent, non-employee directors who are also financially knowledgeable, and not affiliated in any way with the audit accounting firm for which they are responsible to hire and manage. Many other regulations require these levels of independence also for the nominating, compensation, and governance committees where they exist.

2) Director Due Diligence

The increased levels of responsibility now required of directors cuts against directors who sit, often cursorily, on many boards. Directors who spread themselves too thin, or are underqualified for Board membership, will be unable to do justice to the intense work which should be required of each Board member. Sarbanes-Oxley requires that directors spend more time reviewing company disclosures and documents, engaging in analysis, and obtaining related continuing education.

Many private Boards have directors that were chosen because of their willingness to attend meetings, raise capital, or because of special relationships to the company. Today, these individuals if they understand the new responsibilities of a director, may be unwilling to undertake the now substantial risks incumbent upon the office. Even at organizations untouched by apparent scandal, many directors are falling under fire because of their failure to speak up, their willingness to look the other way, their failure to think critically, or for approving exorbitant executive pay packages and the like. Directors are being sued by both private investors and employee stakeholders leading to investigations by the SEC for lapses in duty and diligence. The new regulations are intended not only to extend the responsibilities of directors but to ensure they take greater responsibility when in office. Directors can’t just get by reviewing a package of information delivered to them at the last minute. Directors need to think harder, work longer, realize that they cannot be in a conflict of interest by also receiving work from the company, and that they are liable for possible legal action from any stakeholders.

3) Codes of Business Conduct and Ethics

Companies need to have codes of ethics and conduct that provide guidance in the ethical and legal handling of business matter. As well, there needs to be a mechanism in place, that allows employees to report any unethical or illegal activity without any fear of retribution. The audit committee should oversee the company’s legal and regulatory compliances and establish procedures for the confidential receipt, investigation, and handling of all complaints.

Many of the new requirements increase both the personal risk and the time commitment for each individual director, thus often making it harder to fill Board seats with financially savvy, qualified directors. As directors become harder to find, Board size and Board compensation, which in public companies has risen over 75% in the past five years, will also become issues.

Further, as banks, insurance companies, and other service providers adopt and come to expect these new practices from their public company clients, it is inevitable that they will begin to look toward private companies to meet these same standards. Thus, private companies are wise to let these new rules begin to script their governance practices to ensure that they are less likely to be susceptible to the very problems that have led to the enactment of new governance regulations.

As these new practices continue to evolve, governance initiatives will continue to be designed to ensure the ethical, legal, and responsible enterprise behavior that ensures good corporate performance in times of success and during times of crisis. While businesses exist to serve their stakeholders, they also exist to serve their greater society and civilization. The adoption of governance best practices increases the likelihood that leadership will provide the desired corporate performance while confidently tracking the right course into the future.

¹ Such as, retaliation against whistle blowers, destruction of documents, looking the other way, fraudulently influencing auditors, and other new securities fraud offenses.

² Many maximum jail terms for white-collar crimes are now often in excess of those for such criminal acts such as armed robbery, assault, and negligent murder.

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