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Investors Should Scrutinize Governance of Microcaps


July 07, 2005

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By Louis A. Bevilacqua

This article was originally published in the July 7 (Vol. I, No. 11) edition of The Small Cap Report, ©2005 DealFlow Media, and is here reposted with their permission.

Three years after the enactment of the Sarbanes-Oxley Act, many fund managers assume that they are investing in companies with well-developed corporate governance programs and internal controls, independent directors who look out for stockholder interests, and codes of ethics.

If these assumptions are made about microcap and nanocap companies whose securities are quoted on the Over-the-Counter Bulletin Board or the Pink Sheets, then they could be dead wrong.

Companies whose securities are quoted on the OTCBB or the Pink Sheets are not subject to the post-Sarbanes-Oxley corporate governance listing requirements of the New York Stock Exchange, Nasdaq, or other stock exchanges. For example, Nasdaq- and NYSE-listed companies are subject to the following standards:

  • A majority of the members of the board of directors must be independent;
  • The independent directors are required to meet in executive sessions;
  • The company must have an audit committee consisting entirely of independent directors who are all financially literate;
  • The company must have a compensation committee consisting entirely of independent directors; and
  • The company must adopt a code of ethics.

Although OTCBB and Pink Sheet issuers are required to disclose whether or not they have a code of ethics or an audit committee financial expert, nothing obligates those issuers to have a code or a financial expert.

Due diligence is key when investing in microcap and nanocap companies. Most investors spend considerable time on business, financial, accounting, and legal due diligence. Corporate governance is frequently neglected. Understanding a company's corporate governance structure and taking steps to make sure that sufficient investor protections are in place is critical.

For example, if control of a microcap company is in the hands of a relatively small group of principal stockholders and there are too few independent directors on the board, then there may be a heightened risk of self-dealing and improper related-party transactions. This risk could be identified during due diligence and steps may be taken to minimize the risk.

Corporate governance information requests should be included in an investor's standard due diligence inquiry. Prior to making an investment, the investor should know:

  • Whether any committees of the board have been established;
  • What voting agreements, proxies, or stockholder agreements exist;
  • What corporate governance documents are utilized by the company in addition to its certificate of incorporation and bylaws (e.g., code of ethics, committee charters, corporate governance policies, etc.);
  • How frequently do the board and its committees meet and how frequently are internal controls discussed;
  • How many independent directors are on the board and on what basis was the independence determination made;
  • Do any of the directors qualify as an audit committee financial expert and the basis for that determination;
  • What types of related party transactions have transpired in the past and what steps were taken to ensure that these transactions were fair;
  • What controls are in place to ensure proper and timely reporting under federal securities laws; and
  • Does the company's Web site disclose its governance practices and policies?

Private placement investors can help ensure that OTCBB and Pink Sheet companies maintain sufficient corporate governance standards by requiring the adoption of a formal corporate governance program as a condition of their investments. The investor can then avail himself of many of the protections of Sarbanes-Oxley that are not usually afforded to microcap investors.

Furthermore, the investor can pick and choose which corporate governance protections to require. That way, he can avoid unnecessarily burdening the company with the cost of requirements that add little benefit. For example, an investor might require that a development stage microcap issuer have an independent audit committee with members that are financially literate, but might not require that the committee include a financial expert. The financial statements of a development stage company are typically rather simple and the cost, in terms of personal liability insurance and fees to retain an independent director who also qualifies as a financial expert, may not be worth the potentially marginal benefits.

Requiring a written corporate governance program will also prepare the issuer for an eventual exchange or Nasdaq listing. By grooming the issuer in this way, the investor is adding value to his investment.

Louis A. Bevilacqua is a partner in the business department at Thelen. He is a securities lawyer and has worked with NYSE- and Nasdaq-listed companies and with microcap and nanocap public companies.

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