SEC Advisory Committee Approves 404 Exemptions, More

A closely watched advisory panel to the Securities and Exchange Commission approved preliminary recommendations it will submit to the SEC in the spring, including one that would exempt most public companies from certain provisions of Sarbanes-Oxley.

At a Dec.14 meeting, the SEC Advisory Committee on Smaller Public Companies voted to exempt microcap companies—as defined by the committee—from Section 404 of SOX, which requires that companies report on their internal control over financial reporting, and that their outside auditors to attest to the controls' effectiveness. The internal control provisions of SOX have sparked the most controversy among the issuer and auditor communities, largely because of the because of the costs associated with compliance.

The advisory committee also recommended exempting certain smaller public companies from the external audit requirement of Section 404, subject to certain conditions.

Dolan

Janet Dolan, chair of the group’s internal controls subcommittee, which recommended the exemptions, said that while the group believes that a number of requirements of SOX “are very effective” and can be implemented by companies of all sizes at reasonable cost, the group concluded that the way the audit attestation requirement of 404 has been implemented “exceeds the intended benefits of the law.”

“There’s no way to right size AS2 [the Public Company Accounting Oversight Board’s Auditing Standard No. 2] for small and micro companies,” said Dolan, who is the CEO of $507.8 million industrial equipment maker Tennant Company. Dolan noted that microcap and smaller companies are “greatly disadvantaged” by the standard’s “one-size-fits-all" approach.

New Definitions

To fall under the committee’s definition of microcap, companies would have to have a market cap of the lower 1 percent of all public companies (about $100 million to $125 million) and revenue of $125 million or less. To be considered a smaller public company, companies would have to be in the bottom 6 percent of total market cap (roughly $125 million to $750 million) and have revenues of $250 million or less.

About 80 percent of all U.S. public companies would fall into the “smaller” category, according to the committee. The committee noted that the 20 percent of companies that would remain subject to SOX 404 in its entirety under those tests account for 94 percent of the total U.S. market cap.

Under the proposals, in order to be exempt, companies would be subject to all other SEC and stock exchange rules, and those not listed on an exchange would have to meet certain corporate governance standards set by the committee.

The subcommittee further recommended that if the SEC decides not to exempt smaller companies from the external audit provision of SOX 404, the Commission should direct the Public Company Accounting Oversight Board to develop a new standard (dubbed ASX) for the external audit requirement for smaller companies. “Those companies still need a cost effective external audit for their internal controls,” said Dolan, adding that “We don’t make this recommendation lightly—asking for new standard is a very risky proposition.”

Schacht

While the committee passed the recommendations, the vote was not unanimous. Dissenting from the recommendations for exemption was committee member Kurt Schacht, executive director of the CFA Centre for Financial Market Integrity. Schacht noted that it wasn’t clear whether the committee’s recommendations for such broad exemptions are within the SEC’s legal authority. “It is clear, I think, to all of us that something needs to be done for small companies,” he said. “But I think giving them a pass on any verification and any oversight of internal controls will come back to haunt us.”

30 Preliminary Recommendations

The subcommittee chaired by Dolan also recommended that there should be additional guidance and clarity and amendments to the PCAOB’s AS2, if necessary, by the SEC, COSO and the PCAOB, and that the SEC should consider exemptions for special cases, such as debt-only issuers, biomedical companies and IPOs.

SUBCOMMITTEE SPEAKS

The excerpt below is from Slide 46 of the Preliminary Report of the Internal Controls Subcommittee to the Advisory Committee on Smaller Public Companies, dated Dec. 7, 2005. Mentions of "S404" refer to Section 404 of The Sarbanes-Oxley Act:

Recommendations

Exempt Microcap companies from S404, subject to certain conditions;

Exempt Smaller Public Companies from the external audit requirements of S404, subject to certain conditions;

The subcommittee strongly endorses recommendation #2. However, if the Commission believes that public policy requires some level of auditor reporting on Smaller Public Company controls, preventing the adoption of recommendation #2, then as an alternative, we recommend the SEC change its rule for the implementation of the external audit requirement of S404 to a cost-effective standard (ASX) providing for an external audit of the design and implementation of internal controls;

Additional guidance [from COSO, the SEC, and the PCAOB];

Certain special cases to be granted S404 relief.

Source:

Preliminary Report of the Internal Controls Subcommittee to the Advisory Committee on Smaller Public Companies

However, the committee’s recommendations aren’t final. According to committee co-chair Herb Wander, the group will meet again early next year to vote on a draft of its report, and to release it to the public for comment. That meeting will be held Jan. 23, 2006, in Washington, D.C., which is two weeks later than originally scheduled—the delay will help ensure the committee has time to get the draft report in order. After comments have been reviewed and considered, the committee would then meet again to finalize the report before sending it to the SEC; the panel’s final report is due in April, 2006.

Early in the meeting, Wander advised the committee members that prioritization of all the ideas would be critical to success. “We’re not going to be as successful if we have 60 or 70 recommendations to make to the SEC,” he said, urging them to prioritize those that are really important. In all, the four subcommittees developed more than 30 preliminary recommendations.

Public companies of all sizes have been anxiously awaiting the panel’s final recommendations, since SEC chairman Christopher Cox has said that the Commission will give great weight to its recommendations. During the meeting, Wander noted that Sen. Michael Enzi (R-Wyoming), recently sent a letter to Chairman Cox asking the Commission to give “due consideration to the committee’s recommendations.”

In September, 2005, the SEC delayed by a year the effective date for the implementation of Section 404 for smaller companies—a move that had been recommended the prior month by the advisory committee. Last week, in line with another recommendation by the committee, the SEC approved final rules that kept all but the largest of companies from having to file their periodic reports in less time (see related coverage in box above, right).

If adopted by the SEC, the panel’s recommendations could provide immediate relief from SOX 404 for many companies. In public comments made last month in Denmark, Commissioner Cynthia Glassman said she would be open to the possibility of modifying the internal control provisions of Sarbanes-Oxley for smaller issuers. “If we do not see a meaningful refocus and a downward trend in implementation costs, I believe that the Commission and the PCAOB should consider ways of making the 404 process more effective and less burdensome, including possibly revisiting the requirements of PCAOB's Audit Standard No. 2,” she said in a Nov. 17 speech to the Conference on Listed Companies and Legislators in Dialogue Danish Ministry of Economic and Business Affairs. “Moreover, I expect to be receptive to recommendations for modification of the 404 process for smaller issuers, domestic and foreign.”

Related documents, coverage and resources are available from the box above, right.