Small caps have had a rough ride since Congress enacted Sarbanes-Oxley legislation, and the trip has got even rockier with the new Nasdaq and NYSE rulings passed by the SEC. Making all companies equally accountable has meant that small caps have had to bear the same burden as their larger counterparts – so they have to report their financials, meet listing requirements and address transparency issues.
To find out what corporate secretaries in smaller companies are up against we spoke to several – and all expressed frustration with what they view to be the broad-brush implementation of Sarbanes-Oxley and the new Nasdaq listing requirements. Small caps are still on the same playing field in terms of corporate governance responsibilities, so the biggest challenge they face is how to appease the ethics tiger while continuing to manage and grow their business.
“The problem with Sox is that Congress rushed to pass sweeping legislation that wound up punishing the innocent with the guilty,” argues Wayne Lewis, executive vice president and corporate secretary of Valley National, a small commercial bank based in Virginia. “The likes of Enron and WorldCom represented only a tiny fraction of American companies. Yet all firms now have new compliance requirements that over time might cost the economy an amount approaching or exceeding the fraud committed by the bad-apple companies.”
There is a laundry list of issues smaller companies face in meeting the raft of regulations, not the least of which is cost. Many smaller companies simply don’t have the resources to hire an army of lawyers, outside consultants and other experts that Fortune 500 companies can readily tap to assist them in understanding and adapting to the new regime.
“You’re balancing the desire to provide greater disclosure to shareholders and the investment community in general with the cost,” explains David Ferrera, general counsel and corporate secretary of New York-based Anaren Microwave, a manufacturer of microwave signal distribution equipment. “Regardless of the cost, there’s going to be a disproportionate effect on small-cap companies,” he comments.
Getting a handle on options
In the boardroom of smaller companies the problems are particularly pressing. Take stock options, for example. Currently, all companies are searching for new ways to provide compensation incentives, but traditionally options have been more important in motivating employees at small firms. During the 1990s in Silicon Valley, for example, stock options were key to attracting talent at small technology start-ups.
Corporate secretaries are eyeing the issue warily. “I don’t think the question is if -- it’s when,” says Ferrera. “If companies were required to expense options, the amount could be relatively substantial, which could have a chilling effect on the continued use of options.”
Ferrera, who is also attorney at Bond Schoeneck & King in New York, believes one difficulty with expensing options is how to treat “underwater options,” or options that are never exercised. “There’s an adverse impact {from this} on small-cap companies,” he says.
Robert Belcher, CFO, corporate secretary and treasurer of Memry, notes, “We believe we’re going to be required to expense options, and we’re trying to balance this additional cost with the motivation and reward we can provide our senior managers.” Memry isn’t the only small cap struggling with his issue, either.
“Our board has determined that if debt restructuring takes place, it will continue to use a substantial portion of stock options with a mix of performance-vested restrictive stock units,” says Barbara Blackford, vice president, general counsel and corporate secretary at AirGate. “In other words, executives wouldn’t receive stock unless performance targets are met.”
As new rules call for the majority of board members to be independent, small caps face the challenge of attracting and retaining outside directors without having to spend a larger percentage of profits on increased directors’ fees. In addition, audit committee members now have greater responsibilities post-Sox and have to exert more time and effort on governance matters, and at least one member of the committee has to have financial expertise. This could lead to over fishing in the small pool of candidates.
Directors at smaller companies also get smaller compensation, which could pose a problem. “That might have been tolerable pre-Sox and pre-Enron, but won’t be any more,” says David Albin, a partner in New York law firm Finn Dixon & Herling and general counsel for Memry.
Cost of outside help
Among the governance issues of most concern to small caps are the requirements for increased corporate transparency and disclosure – which could necessitate more internal controls and expensive procedures – and accelerated filling requirements. Some small caps are dealing with this requirement by enlisting the help of an outside auditing firm.
For Memry, which produces shaped memory alloys for the medical device industry, it was a big challenge for Belcher to meet requirements that CEOs and CFOs certify the adequacy of the company’s internal controls and procedures. The company recently selected one of the big four accounting firms as its public auditor because it felt the new firm could provide enhanced training and education for its audit committee members, Belcher says.
“Right now,” he explains, “our CEO and I have to certify our financials quarterly and annually, and soon we will also have an annual audit of the adequacy of those controls and procedures. For a small firm, which does not have an internal control function, such an effort requires the participation of a large percentage of managers. We estimate our total budget for outside accounting services will rise by 50 percent to 70 percent over a two-year period.”
Lewis makes no bones about his distaste for Sarbanes-Oxley. “We’re a small bank holding company with 80 employees and we’re treated exactly the same under Sarbanes-Oxley as Microsoft or Wal-Mart,” he explains. “As such, we’re already subjected to some of the most extensive and expensive regulatory scrutiny there is. We’re examined and monitored constantly by the Federal Reserve, the FDIC and our state banking commission.
“We’re going to have to hire more staff and more consultants, spend more money on lawyers, and divert existing staff from profit-producing activities. All told, I wouldn’t be surprised in 2004 {if} our little company spends up to $100,000 on Sarbanes-Oxley.”
AirGate has already faced special challenges over the past few years. One of them was the collapse of the wireless sector – from a market capitalization at the end of 2001 of $1 bn, AirGate’s market cap has plummeted to $75 mn today, and it has been as low as $7 mn, notes Blackford.
In late 2002 the company changed chief financial officers and today has only one person remaining from the previous accounting staff. “We have been rebuilding our accounting function, in addition to facing the added controls required by Sarbanes-Oxley,” comments Blackford. But AirGate knew it couldn’t solve its problems alone and internally. “Basically, we’ve met that challenge by looking to outside resources to help provide the tools, staffing and expertise to comply with Sarbanes-Oxley,” says Blackford.
Between a rock and a hard place
So where to small caps go from here? There are as many solutions offered on how to fix the system as there are experts. Albin, for one, has some definite suggestions on dealing with the issues of directors, corporate transparency and stock options.
“Small-cap companies are likely to react in one of two ways on the directors problem,” he points out. “Those that truly want to be public companies will have to pay more money to attract quality directors or quality candidates will not be interested. CEOs may even be less likely to take their companies public in the first place, if they don’t want to lose the control that will be shifted from management to directors as a result. Alternatively, if they do go public, they might be satisfied with less than quality candidates who are less likely to exercise independent judgment.
“Until such time as small-cap companies start being sued for issuing projections that aren’t met, whether or not the suits ultimately have merit, it’s not likely that management will be able to stand up to the investment community and refuse to issue forecasts,” says Albin.
As for stock option plans, he feels that “while there may be some cutting back of stock options to lower-level employees, many small-cap companies will feel compelled to continue their stock-option plans as they have been traditionally used, and live with the charge against earnings.”
Raphael Russo, an attorney with New York law firm Paul, Weiss, Rifkind, Wharton & Garrison, recommends senior management of a small cap set the appropriate “tone at the top.” Right now, smaller companies are caught in the dilemma of needing the same transparency and reporting infrastructure as larger companies but without the resources or reputation to attract and retain experienced professionals and employees. It’s therefore important for everyone in the organization to take a cue from senior management that good governance and transparency are important.
“Senior managements of small firms obviously have a lot on their plates and wear many hats, but in the current environment there can be no shortcuts on these issues,” says Russo. “But setting the appropriate tone, senior management members can get the most from their resources.”
Finding That Expert
The governance issue of most concern to small caps is the requirement that audit committees retain at least one financial expert.
Robert Belcher, Memry’s CFO, corporate secretary and treasurer, says even though the current chairman of the company’s audit committee “would probably meet the test for financial expert,” Memry plans to search for someone else to fill the position during the next twelve months. “We all feel it would be useful to have someone with a little more time to devote to the increased responsibilities that accompany the position,” Belcher explains.
“We don’t think at this point we have somebody who qualifies, which is not to say we don’t have an excellent audit committee,” says Wayne Lewis, executive vice president and corporate secretary of Valley Financial. “We have a retired high-ranking internal fraud auditor from a Fortune 500 company, a lawyer and a licensed broker on the committee. We think this diversity of background is probably at least as beneficial as a so-called financial expert.”
Lewis says Valley Financial is trying to decide “whether to look for one or say we don’t have one and explain why not.” He worries that other audit committee members might defer to the financial expert, who might come to dominate the committee.
AirGate’s corporate secretary Barbara Blackford admits that attracting directors to serve on the board “has been a bear. Our board went from nine members in 2001 to three members in 2003. We have two independents plus the CEO.”
Blackford says the company has increased its director compensation and put in place a special retention fee for directors who stay with the firm through its debt restructuring. “We had 19 board meetings in 2003 and the two independent directors played the total role for both the audit and compensation committees. Fortunately, both are financial experts,” she notes. “We have recruited a fine slate of directors to join the board when and if the debt restructuring is completed. We found them through looking both inside and outside our industry and by considering diverse candidates, including women, and a wider geographic base. A lot of small companies tend to cluster geographically and not look beyond their state.”
All the companies Corporate Secretary magazine spoke to {with the exception of AirGate} have had little difficulty in attracting independent directors thus far, but all say they will probably have to increase directors’ fees eventually to continue attracting qualified candidates. And both Memry and Valley National say that, out of necessity, they will probably launch outside searches for suitable financial experts to serve on their audit committees.