Tyco. Enron. WorldCom. Adelphia. If you're a director of a private family-owned company, you may assume that these Wall Street problems have nothing to do with you or your business. That assumption is wrong-and potentially dangerous.
These and other recent cases of corporate fraud have fueled a backlash that's starting to ripple through to private companies. And family businesses may be more at risk than those not owned by family. Potential conflicts of interest are especially likely to lurk within family companies because directors often juggle many other roles, such as shareholder, manager and family member.
The Sarbanes-Oxley Act of 2002, which mandated sweeping reforms to several aspects of governance at publicly traded corporations, is quite likely to affect your company as well as its managers and directors. Here are some of the Sarbanes-Oxley rules:
- Only outsiders can serve on the audit, compensation and nominating committees.
- CEOs and CFOs must certify that they agree with financial statements.
- Financial disclosure practices have been improved.
- Off-balance-sheet arrangements have been limited.
- Insider transactions must be disclosed.
The regulators may not be at your heels. But the stage is set for potential shareholder lawsuits and other unpleasant complications. After all, according to a Wall Street Journal report, a study of more than 200 corporate fraud cases brought before the Securities and Exchange Commission between 1987 and 1997 revealed that most financial-statement fraud is committed by companies with tiny market capitalizations. The spotlight is bound to broaden and burn more brightly as more and more abuses surface.
Even if you've done nothing illegal or unethical, as a director you could be held responsible for illegal or unethical conduct committed by employees. Directors are on the firing line of any lawsuit against the company or its managers.
Professionalizing your company
The most effective way to avoid litigation is to prevent actual or potential conflicts of interest-or even the appearance of such conflicts. The best way to do that is by professionalizing your company. That includes establishing a company code of ethics and code of conduct as well as a conflict-of-interest policy. You must ensure that all stakeholders clearly understand the company's codes and policies and know what constitutes a conflict of interest. All constituents must also understand the procedures for dealing with violations of these policies.
Another strategy is to embrace the Sarbanes-Oxley rules listed above, even though you are not legally required to do so. In many family businesses, board members represent one branch of the family and feel compelled to act according to the interests of that branch. But a director has a responsibility to oversee the entire organization and protect all shareholders-not just the family members who gave you the mandate to serve on the board.
That's why my own family business-a fourth-generation global market leader in advanced metal transformation and coatings, based in Belgium-is adapting our governance system to allow for greater independence and to reduce any potential conflict of interest. For example, while most of our directors are family members, the majority of the audit and nominating committee members are outsiders. We also have reduced family representation on subsidiary boards. Sarbanes-Oxley does not prohibit family members from sitting on subsidiary boards, but we have taken extra steps to avoid the appearance of a conflict of interest.
Family-style conflicts of interest
Here are some examples of conflicts of interest. Family companies must develop formal policies to address them.
- A vendor in the family. Suppose one of your shareholders or board members is an architect or contractor, or a supplier of materials your company needs. Hiring that person might constitute a conflict of interest. Solution: First, your relationship to that person must be disclosed. Second, the person can be hired only after an arm's-length bidding procedure.
- Seller and buyer in one. A director may also be trustee of an ESOP. Wearing the trustee hat, that director must defend the interest of the beneficiaries of the trust-employees-by trying to negotiate the lowest price for shares it buys from the company. Wearing the director's hat, he or she must try to obtain the highest share price, for the benefit of the company and other shareholders. Solution: Hire an outside appraiser. Better yet, have the ESOP and the board each hire its own appraiser; if there's a discrepancy in the share prices each divines, meet in the middle.
- Hiring in the family. Ad hoc hiring of family members and over- or under-paying them can lead to resentment not only among other family shareholders, but also among non-family employees. Solution: Follow the Sarbanes-Oxley recommendation that nominating and compensation committees be composed entirely of outside directors. Have a written policy on hiring of family and non-family employees, and base compensation on market rates.
- Perk abuses. Pledging company shares as collateral for a personal bank loan could put the company in financial jeopardy. If the family member defaults on that loan and the bank wants to cash in those private-company shares, the company may need to shell out money to buy them back. In addition, excessive use of expense accounts, questionable travel and other perks taken by family members can incur the wrath of shareholders and employees. Solution: Disclosure. Written policies. Moderation.
Reassuring key outsiders
Sarbanes-Oxley has dampened the desire of many family companies to go public. But that won't necessarily reduce the pressure to follow some or all of the new rules.
Today's scandal-ridden corporate landscape has spooked bankers, acquirers, insurers and prospective new directors. Some are demanding greater financial and legal accountability from private as well as public companies.
Want to apply for a loan? If you don't follow at least some of these measures, you may have a hard time finding a willing banker, or the loan may be more costly.
Your ability to attract new outside directors and retain the ones you have may depend on the extent to which your policies make them feel confident about your company. And the cost of directors' and officers' insurance is likely to be lower for companies that protect their directors from liability.
The tendency of family business directors to wear many hats creates conflict-of-interest traps. To avoid getting ensnared, consider implementing key portions of Sarbanes-Oxley, and create written ethics and conflict-of-interest policies.