With the clock ticking on regulatory efforts to improve implementation of Sarbanes-Oxley Section 404, a high-profile committee has offered its two cents on how to make compliance with SOX 404 less burdensome.
The recommendations come from a group of leaders in the investor, business, finance, law, accounting, and academic communities that is formally known as The Committee on Capital Markets Regulation.
The group—also known as The Paulson Committee, since its formation was blessed by Treasury Secretary Henry Paulson—was established in September to assess how much U.S. public markets may be losing ground to foreign and private markets, and why.
In its 152-page report, issued late last week, the panel said the growth of U.S. regulatory-compliance costs and liability risks are among the factors contributing to a decline in American public-market competitiveness. Also cited: the fact that foreign markets have closed the technology, investor confidence, and liquidity gaps that traditionally favored U.S. markets. The report also noted that more money is now raised outside than inside the United States, and that it’s easier for people to invest abroad.
“For much of the 60 years since the end of World War II, firms raising capital did not so much choose to come to the United States; they came naturally,” the committee wrote. “Today, the forces at work are increasingly different. Firms must choose to come to the United States to raise capital: they do not have to come.”
Many of the group’s 32 recommendations for boosting competitiveness are in line with regulatory efforts already under way by the Securities and Exchange Commission and the Public Company Accounting Oversight Board. Other proposals, such as capping auditor liability, would require new legislation. Six of the major recommendations relate to Section 404.
Keller
Stanley Keller, a partner at the law firm Edwards Angell Palmer & Dodge, says the recommendations on 404 “include a fair amount of low-hanging fruit.”
“They mostly endorse what the SEC and the PCAOB are doing,” including redefining material weaknesses, revamping Auditing Standard No. 2, and providing more guidance on implementation, Keller says.
Statutory Changes Not On Agenda
The group—directed by Harvard Law School professor Hal Scott, and co-chaired by Columbia University business school Dean Glenn Hubbard and Brookings Institution Chairman John Thornton—didn’t recommend any statutory changes to Sarbanes-Oxley. Instead, the panel called for changes to SOX 404 implementation: a redefinition of materiality, more guidance from the PCAOB, and multi-year rotational testing of internal controls permitted within an annual attestation. All those recommendations already have been floated by several groups.
Barbara Roper, director of investor protection at the Consumer Federation of America, says the committee missed the mark.
Roper
“Even if we were to adopt every recommendation on the list, we would’ve done nothing meaningful to change recent IPO trends,” Roper says. “They have fundamentally misunderstood the nature of the problem, and they have prescribed a solution that will do nothing to address the basic forces that are driving companies to list overseas.”
RECOMMENDATIONS
The following key recommendations have been excerpted from the committee’s interim report.
Shareholders Rights
Classified boards should be required to obtain shareholder authorization to adopt
a poison pill, and if this is not done within three months, the pill should
automatically be redeemed.
The Committee endorsed majority, rather than plurality, voting, which is a
cornerstone of shareholder rights, and the Committee will study how it may best
operate.
Shareholders should be given the choice to decide how disputes with their
companies should be resolved – e.g., through arbitration (with or without class
actions), or non-jury trials.
The SEC should resolve issues on ballot access caused by a recent court decision.
Regulatory Process
The SEC and self-regulatory organizations should move to a more risk-based
regulatory process, emphasizing the costs and benefits of new rules. In
weighing the costs and benefits of new rules, regulators should rely on empirical
evidence to the extent possible. Also to the extent possible, regulations should
rely on principles-based rules and guidance.
The SEC should periodically test existing rules to ensure that they still meet
reasonable cost/benefit standards.
Public enforcement bodies like the SEC, Justice Department and state securities
commissioners and attorneys general need to coordinate their activities, providing
for federal precedence where enforcement implications are national in scope.
There should be more effective communication and cooperation among federal
regulators. The President’s Working Group on Financial Markets is one natural
venue for ensuring such cooperation.
Public and Private Enforcement
Greater clarity for private litigation under SEC Rule 10b-5, and from the SEC on
materiality, scienter (knowledge of wrongdoing) and reliance is needed. Criminal
enforcement against companies should be a last resort, reserved for companies
that have become criminal enterprises from top to bottom. We should not hold
outside directors responsible for corporate malfeasance that they cannot possibly
detect.
Public enforcement authorities should not be allowed to threaten corporate
defendants with denial of their employees’ right to due process.
The SEC should protect outside board members against liability from relying in
good faith on the validity of audited financial statements – otherwise, it will be
difficult to attract independent directors to boards.
Congress should explore protecting audit firms against catastrophic loss through
the provision of caps or safe harbors, as do some European countries and as the
European Union is actively considering. Any use of such protection must be
balanced against stiff action against those responsible for misconduct.
Sarbanes-Oxley
The SEC should adopt a more reasonable materiality standard both for internal
controls and financial statements.
The SEC and the PCAOB should adopt enhanced guidance on auditors’ role and
duties in testing for compliance with Section 404.
If a revised Section 404 is too burdensome for small companies ($75 million
market cap and less), even after the general reforms outlined above are
implemented, the SEC should recommend to Congress that small companies be
exempt from auditor attestation and be subject to a more reasonable standard for
management certification.
Source
Interim Report Of The Committee On Capital Markets (Committee On Capital Markets Regulation; Nov. 30, 2006) (11.5 MB)
But Keller says that, at least regarding Section 404, he expects the SEC and PCAOB to “clearly move in the direction that the committee is suggesting.”
“If there’s any controversy, it’s likely to be over the recommended treatment of smaller issuers,” says Keller.
The committee called for the SEC to continue to delay the application of Section 404 to non-accelerated filers (companies with less than $75 million of market capitalization) until proposed changes in materiality, enhanced guidance, and multi-year rotational testing take effect, and to then reassess the costs and benefits of extending 404 to small companies. At that point, it said, “If the costs are still too high relative to the benefits, [the SEC] should ask Congress to consider exempting small companies from the auditor attestation requirement of Section 404 while at the same changing the management certification requirement to one requiring reasonable belief in the adequacy of internal controls.”
Keller notes that the panel’s recommendations regarding smaller issuers “would provide ‘much less relief’ than the SEC Advisory Committee on Smaller Companies had proposed.” The advisory committee urged exempting non-accelerated filers from Section 404, but SEC Chairman Christopher Cox has repeatedly said he opposes exempting any businesses from Section 404 regardless of their size.
McGurn
Noting that the exemption idea released by the SEC’s small ccompany advisory panel last spring “fell to the ground like a chunk of lead,” Pat McGurn, executive vice president at proxy governance firm Institutional Shareholder Services, doesn’t expect the SEC to embrace the Paulson Committee’s exemption plan either.
However, McGurn said “overwhelming bipartisan support” for cutting the cost of 404 compliance provides plenty of political cover for the PCAOB and the SEC to reduce the regulatory burden of 404. He expects leaders at the SEC and PCAOB to announce a set of reforms “that satisfies many of the mainstream concerns voiced in Washington to date.” Those reforms are likely to be unveiled at the SEC’s open meeting on Dec. 13.
The other recommendations are “a mixed bag,” says McGurn, who calls some of the shareholder rights proposals “progressive.”
Other Recommendations
The committee recommended that the SEC should revise its guidance on materiality for financial reporting so scoping materiality is generally defined in terms of a 5 percent pre-tax income threshold. In cases where the 5 percent test wouldn’t be meaningful, it said the SEC should allow companies and auditors to use “reasoned judgment” in choosing other measures to evaluate materiality.
It called for management and auditors to use a multi-year rotational testing approach within an annual attestation for lower risk areas and for the SEC and PCAOB to give guidance on auditor reliance on inputs from existing sources, such as internal auditors and management, in performing control work. It also said the SEC and the PCAOB should adopt enhanced guidance on auditors’ roles in testing.
The panel rejected a “design-only” standard for smaller companies (where outside auditors would assess the overall adequacy of the design of controls and only test effectiveness in limited areas) as unworkable, saying a reliable judgment about design can’t be made without testing effectiveness.
Among other things, the committee said regulators should collect more information on the costs and benefits of Section 404.
The SEC plans to propose guidance for management on implementing Section 404 at its Dec. 13 meeting, while the PCAOB is expected around the same time to propose for comment a new audit standard to supersede AS2. Other items that the Paulson Committee discussed, such as shareholder access to the director nomination process, are also on the SEC’s December rulemaking agenda.
Officials at the SEC declined comment.
Olson
PCAOB Chairman Mark Olson called the report “thoughtful in its analysis of the U.S. market’s competitiveness from both a macro and micro economic perspective, while recognizing the complexities involved in making any conclusive determinations.”
Olson said the recommendations on 404 “are very timely as the PCAOB is in the final stages of developing proposals” for its new standard. He said the board is considering changes to the auditing standard that provide “for a much more efficient, risk-based, scalable implementation.”
“In considering such changes, as regulators, we must assure that investors can have confidence in financial reports of public companies,” he said.
The Council of Institutional Investors, an association of 140 public, union, and corporate pension funds with assets exceeding $3 trillion, supports the recommendations on shareholder rights while calling for those reforms to go further. However, it says if adopted, many of the committee’s other recommendations would “undermine the effectiveness of market watchdogs and weaken critical investor protections.”
While it said the committee raises “legitimate questions about the level of regulation and litigation,” CII said the group views the issues “through far too narrow a prism, by focusing primarily on the market for initial public offerings. IPOs … are not the sole, nor the best, basis on which to judge the health of the U.S. economy or the appropriateness of U.S. rules and laws.”
CII calls the contention that fear of lawsuits and excessive regulation, particularly costs associated with Section 404, have driven the decline in IPO listings “off-base.”
Meanwhile, the U.S. Chamber of Commerce established its own commission last year to study the same issues. Chamber president and chief executive officer Tom Donohue said that group, dubbed the Commission on the Regulation of U.S. Capital Markets in the 21st Century, will consider the committee’s work in its report, slated to be released in March.
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