Editor’s note: This article originally appeared in Grant Thornton’s CEO View’s newsletter.The new set of rules and regulations put into effect by the Sarbanes-Oxley (SOX) Act, the most stringent federal corporate governance law since 1934, may be a driving force behind the upswing in public companies reverting back to private organizations.

SOX calls for public companies to document internal controls, build an independent board of directors that includes a “financial expert,” and certify all financial statements with the chief financial officer’s signature, among an array of other corporate governance rules and regulations.

From increased auditing expenses to changes in the governance structure to higher directors and officers (D&O) insurance premiums, changes enacted in response to SOX are having an effect on the bottom line of many public companies.

According to an estimate by corporate law firm Foley & Lardner in Los Angeles, the cost of being public for a typical middle-market company (with $1 billion or less in annual revenue) has risen to $2.5 million a year from $1.3 million before SOX.

For some companies, the combination of stricter regulations and the higher cost of maintaining public company status is making the grass look greener on the private company side.

“Many of the recent regulatory changes for public companies benefit shareholders by making executives and directors more accountable,” says George Shaw, managing director of Grant Thornton Corporate Finance LLC. “While this is great from a shareholder’s perspective, companies that are publicly traded now face additional burdens. Management really needs to assess the benefits of being public against its associated costs.”

The number of companies weighing the benefits and finding the scale tipping in favor of private company status has been on the rise since the passage of SOX in July 2002. In fact, according to Securities Data Corp, the number of companies going private increased nearly 37 percent from 2001 to 2002.

D&O insurance

While higher auditing fees are one facet of costs associated with implementing SOX, the scrutiny being placed on directors and officers who sign off on public company financial statements may lead to increased D&O insurance costs as well.

D&O insurance is professional liability coverage for legal expenses and liability to shareholders, bondholders, creditors or others caused by actions or omissions by a director or officer of a corporation.

“Given the current business environment, shareholders and individuals are more inclined to sue directors and officers, increasing the need for and cost of the insurance,” says Patrick Nolan, an insurance broker with A.J. Renner and Associates/Vista Insurance Partners of Illinois, a wholesale insurance brokerage firm in Chicago.

But, the escalating cost of D&O insurance many not be the only hurdle public companies face. According to Nolan, companies may not be able to purchase coverage at all.

“Amid higher scrutiny and liability fears, insurers today are more sensitive to corporate governance issues,” he says.

“Insurance carriers have been losing ridiculous amounts of money in the D&O marketplace. Without an established history with a good carrier, you may have problems finding insurance right now — regardless of your litigation history.”

Nolan notes, however, that private companies have a better chance of acquiring D&O insurance at more appealing rates than public firms. “While prices have risen for both private and public companies, D&O percentage premium increases for public companies have been much greater in light of accounting debacles and increased financial restatements.

“As a result,” he says, “private companies are more attractive to insurers than potential litigation-laden public companies.”

Conducting a reverse IPO

Assessing the feasibility of going private, however, and going through the subsequent “reverse IPO” process can be complicated.

The Securities and Exchange Commission allows a company with fewer than 300 shareholders to de-register its securities and become a private company. This process is typically done through a negotiated merger or tender offer, both of which are usually put to a shareholder vote.

Companies returning to private status must also consider how to fund the purchase of public shares.

“Companies considering going private have to pay for the services of bankers, attorneys and accountants,” Grant Thornton’s Shaw says. “Normally there is a special committee composed of independent board members appointed to evaluate the fairness of the offer on behalf of the public shareholders. The special committee hires its own advisors, resulting in additional costs.”

These costs are in addition to raising the capital to buy out the public shareholders. In most cases, this capital may be more expensive than the cost of the capital as a public company, thereby putting a financial burden on the company and restraining investment for growth.

Shaw advises that companies making a successful reverse IPO transition often share the following characteristics:

  • low market capitalization;
  • thin trading volume;
  • limited analyst coverage;
  • strong projected cash flow; and
  • well-respected management.
  • “With the public markets still rocky, the benefits of being a public company certainly have diminished for some small and mid-sized companies,” Shaw says. “If you have been thinking about it, now may be the time to explore the possible benefits and challenges of doing a reverse IPO.”

    He concludes by noting that many of the easier reverse IPOs have taken place during 2002 and 2003. “During the next 12 months, I would expect to see more merger transactions between small- and mid-cap public companies as they explore other options of dealing with the new regulatory requirements and market conditions.”

    Reprinted with permission from Grant Thornton’s Fall 2003 CEO View’s newsletter. Grant Thornton is the world’s leading accounting, tax and business advisory organization dedicated to mid-size companies. Through its network of 585 offices in 110 countries, including 50 offices in the U.S., partners of the member firms of Grant Thornton provide personal attention and seamless service delivery to public and private clients around the globe.

    Grant Thornton: www.grantthornton.com