Exposure Draft of Final Report of Advisory Committee on Smaller Public Companies, 11090-11133 [06-1992]
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Federal Register / Vol. 71, No. 42 / Friday, March 3, 2006 / Notices
SECURITIES AND EXCHANGE
COMMISSION
[Release Nos. 33–8666; 34–53385; File No.
265–23]
Exposure Draft of Final Report of
Advisory Committee on Smaller Public
Companies
Securities and Exchange
Commission.
ACTION: Publication of Exposure Draft of
Advisory Committee Final Report,
Request for Public Comment.
AGENCY:
SUMMARY: The Securities and Exchange
Commission Advisory Committee on
Smaller Public Companies is publishing
an exposure draft of its Final Report and
requesting public comment on it.
DATES: Comments should be received on
or before April 3, 2006.
ADDRESSES: Comments may be
submitted by any of the following
methods:
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• Use the Commission’s Internet
submission form (https://www.sec.gov/
info/smallbus/acspc.shtml); or
• Send an e-mail message to rulecomments@sec.gov. Please include File
Number 265–23 on the subject line; or
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Paper Comments
• Send paper comments in triplicate
to Nancy M. Morris, Federal Advisory
Committee Management Officer,
Securities and Exchange Commission,
100 F Street, NE., Washington, DC
20549–1090. You may also fax your
submission to 202–772–9324, Attn:
Federal Advisory Committee
Management Officer.
All submissions should refer to File No.
265–23. This file number should be
included on the subject line if e-mail is
used. To help us process and review
your comments more efficiently, please
use only one method. The Commission
will post all comments on its Web site
(https://www.sec.gov./info/smallbus/
acspc.shtml).
Comments also will be available for
public inspection and copying in the
Commission’s Public Reference Room,
100 F Street, NE., Washington, DC
20549. All comments received will be
posted without change; we do not edit
personal identifying information from
submissions. You should submit only
information that you wish to make
available publicly.
FOR FURTHER INFORMATION CONTACT:
Questions about this release should be
referred to William A. Hines, Special
Counsel, at (202) 551–3320, or Kevin M.
O’Neill, Special Counsel, at (202) 551–
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3260, Office of Small Business Policy,
Division of Corporation Finance,
Securities and Exchange Commission,
100 F Street, NE., Washington, DC
20549–3628.
SUPPLEMENTARY INFORMATION: The SEC
Advisory Committee on Smaller Public
Companies is publishing an exposure
draft of its Final Report to solicit public
comment on the draft. The draft
contains proposed recommendations of
the Committee on improving the current
securities regulatory system for smaller
companies. All interested parties are
invited to submit their comments in the
manner described above. The Advisory
Committee is especially interested in
receiving comments from investors in
microcap and smallcap companies, as
well as from their managements. The
draft has been approved as an exposure
draft by the Advisory Committee. It does
not necessarily reflect any position or
regulatory agenda of the Commission or
its staff.
The text of the exposure draft follows:
Final Report of the Advisory Committee
on Smaller Public Companies to the
U.S. Securities and Exchange
Commission
*Access to each appendix is available by
clicking its name on the copy of this page
posted on the Internet at https://www.sec.gov/
info/smallbus/acscp-finalreport_ed.pdf.
Transmittal Letter—SEC Advisory
Committee on Smaller Public Companies
Washington, DC 20549–3628.
[April 23], 2006
The Honorable Christopher Cox, Chairman,
U.S. Securities and Exchange Commission,
100 F Street, NE, Washington, DC 20549–
1070.
Dear Chairman Cox: On behalf of the
Commission’s Advisory Committee on
Smaller Public Companies, we are pleased to
submit our Final Report.
[Contents of letter to be included in Final
Report.]
Respectfully submitted on behalf of the
Committee.
Herbert S. Wander,
Committee Co-Chair.
James C. Thyen,
Committee Co-Chair.
Enclosure
cc: Commissioner Cynthia A. Glassman
Commissioner Paul S. Atkins
Commissioner Roel C. Campos
Commissioner Annette L. Nazareth; Ms.
Nancy M. Morris
[April 23], 2006
Members, Official Observers and Staff
of Advisory Committee
Table of Contents
Transmittal Letter
Members, Official Observers and Staff of
Advisory Committee
Part I. Committee History
Part II. Scaling Securities Regulation for
Smaller Companies
Part III. Internal Control Over Financial
Reporting
Part IV. Capital Formation, Corporate
Governance and Disclosure
Part V. Accounting Standards
Part VI. Epilogue
Part VII. Separate Statement of Mr. Jensen
Part VIII. Separate Statement of Mr. Schacht
Part IX. Separate Statement of Mr. Veihmeyer
Appendices*
A. Official Notice of Establishment of
Committee
B. Committee Charter
C. Committee Agenda
D. SEC Press Release Announcing Intent
To Establish Committee
E. SEC Press Release Announcing Full
Membership of Committee
F. Committee By-Laws
G. Request for Public Comments on
Committee Agenda
H. Request for Public Input
I. Background Statistics for All Public
Companies
J. Universe of Publicly Traded Equity
Securities and Their Governance
K. List of Witnesses
L. Letter from Committee Co-Chairs to SEC
Chairman Christopher Cox dated August
18, 2005
M. SEC Statement of Policy on Accounting
Provisions of Foreign Corrupt Practices
Act
Members
Herbert S. Wander, Co-Chair, Partner,
Katten Muchin Zavis Rosenman (Ex
Officio Member of All Subcommittees
and Size Task Force)
James C. Thyen, Co-Chair, President and
CEO, Kimball International, Inc. (Ex
Officio Member of All Subcommittees,
Chairperson of Size Task Force)
Patrick C. Barry, Chief Financial Officer
and Chief Operating Officer, Bluefly,
Inc. (Accounting Standards
Subcommittee, Size Task Force)
Steven E. Bochner, Partner, Wilson
Sonsini Goodrich & Rosati,
Professional Corporation
(Chairperson, Corporate Governance
and Disclosure Subcommittee)
Richard D. Brounstein, Executive Vice
President and Chief Financial Officer,
Calypte Biomedical Corp. (Internal
Control Over Financial Reporting
Subcommittee)
C.R. ‘‘Rusty’’ Cloutier, President and
Chief Executive Officer, MidSouth
Bancorp, Inc. (Corporate Governance
and Disclosure Subcommittee)
James A. ‘‘Drew’’ Connolly III,
President, IBA Capital Funding
(Capital Formation Subcommittee)
E. David Coolidge III, Vice Chairman,
William Blair & Company
(Chairperson, Capital Formation
Subcommittee)
Alex Davern, Chief Financial Officer
and Senior Vice President of
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Manufacturing and Information
Technology Operations, National
Instruments Corp. (Internal Control
Over Financial Reporting
Subcommittee, Size Task Force)
Joseph ‘‘Leroy’’ Dennis, Executive
Partner, McGladrey & Pullen
(Chairperson, Accounting Standards
Subcommittee)
Janet Dolan, Former Chief Executive
Officer, Tennant Company
(Chairperson, Internal Control Over
Financial Reporting Subcommittee)
Richard M. Jaffee, Chairman of the
Board, Oil-Dri Corporation of America
(Corporate Governance and Disclosure
Subcommittee, Size Task Force)
Mark Jensen, National Director, Venture
Capital Services, Deloitte & Touche
(Internal Control Over Financial
Reporting Subcommittee)
Deborah D. Lambert, Co-Founder,
Johnson Lambert & Co. (Internal
Control Over Financial Reporting
Subcommittee)
Richard M. Leisner, Partner, Trenam
Kemker (Capital Formation
Subcommittee, Size Task Force)
Robert E. Robotti, President and
Managing Director, Robotti &
Company, LLC (Corporate Governance
and Disclosure Subcommittee)
Scott R. Royster, Executive Vice
President & Chief Financial Officer,
Radio One, Inc. (Capital Formation
Subcommittee)
Pastora San Juan Cafferty, Professor,
School of Social Service
Administration, University of Chicago
(Corporate Governance and Disclosure
Subcommittee)
Kurt Schacht, Executive Director, CFA
Centre for Financial Market Integrity
(Internal Control Over Financial
Reporting Subcommittee)
Ted Schlein, Managing Partner, Kleiner
Perkins Caufield & Byers (Capital
Formation Subcommittee)
John B. Veihmeyer, Deputy Chairman,
KPMG LLP (Accounting Standards
Subcommittee)
Official Observers
George J. Batavick, Member, Financial
Accounting Standards Board (FASB)
(Accounting Standards
Subcommittee)
Daniel L. Goelzer, Member, Public
Company Accounting Oversight
Board (Internal Control Over
Financial Reporting Subcommittee)
Jack E. Herstein, Assistant Director,
Nebraska Bureau of Securities (Capital
Formation Subcommittee)
SEC Staff
Alan L. Beller, Director (until February
2006) Division of Corporation Finance
Martin P. Dunn, Deputy Director,
Division of Corporation Finance
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Mauri L. Osheroff, Associate Director
(Regulatory Policy), Division of
Corporation Finance
Gerald J. Laporte, Committee Staff
Director Chief, Office of Small
Business Policy, Division of
Corporation Finance
Kevin M. O’Neill, Committee Deputy
Staff Director, Special Counsel, Office
of Small Business Policy, Division of
Corporation Finance
Cindy Alexander, Assistant Chief
Economist, Corporate Finance and
Disclosure, Office of Economic
Analysis
Anthony G. Barone, Special Counsel,
Office of Small Business Policy,
Division of Corporation Finance
Jennifer Burns, Public Accounting
Fellow, Office of the Chief
Accountant
Mark W. Green, Senior Special Counsel,
Division of Corporation Finance
Kathleen Weiss Hanley, Economic
Fellow, Office of Economic Analysis
William A. Hines, Special Counsel,
Office of Small Business Policy,
Division of Corporation Finance
Alison Spivey, Associate Chief
Accountant, Office of the Chief
Accountant
Executive Summary 1
Background
The U.S. Securities and Exchange
Commission (the ‘‘Commission’’ or
‘‘SEC’’) chartered the Advisory
Committee on Smaller Public
Companies on March 23, 2005. The
Charter provided that our objective was
to assess the current regulatory system
for smaller companies under the
1 This report has been approved by the Committee
and reflects the views of a majority of its members.
It does not necessarily reflect any position or
regulatory agenda of the Commission or its staff.
Note on Terminology: To aid understanding and
improve readability, we have tried to avoid using
defined terms with initial capital letters in this
report. We generally use the terms ‘‘public
company’’ and ‘‘reporting company’’
interchangeably to refer to any company that is
required to file annual and quarterly reports with
the SEC in accordance with either Section 13 or
15(d) of the Securities Exchange Act of 1934, 15
U.S.C. 78m or 78o(d). When we refer to ‘‘microcap
companies,’’ we are referring to public companies
with equity capitalizations of approximately $128
million or less. When we discuss ‘‘smallcap
companies,’’ we are talking about public companies
with equity capitalizations of approximately $128
million to $787 million. We believe these labels
generally are consistent with securities industry
custom and usage. When we refer to ‘‘smaller
public companies,’’ we are referring to public
companies with equity capitalizations of
approximately $787 million and less, which
includes both microcap and smallcap companies.
We recognize that formal legal definitions of these
terms may be necessary to implement some of our
recommendations that use them, and we discuss
our recommendations as to how some of them
should be defined in Part II.
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securities laws of the United States, and
make recommendations for changes.
The Charter also directed that we
specifically consider the following areas
of inquiry, including the impact in each
area of the Sarbanes-Oxley Act of 2002: 2
• Frameworks for internal control
over financial reporting applicable to
smaller public companies, methods for
management’s assessment of such
internal control, and standards for
auditing such internal control;
• Corporate disclosure and reporting
requirements and federally imposed
corporate governance requirements for
smaller public companies, including
differing regulatory requirements based
on market capitalization, other
measurements of size or market
characteristics;
• Accounting standards and financial
reporting requirements applicable to
smaller public companies; and
• The process, requirements and
exemptions relating to offerings of
securities by smaller companies,
particularly public offerings.
The Charter further directed us to
conduct our work with a view to
furthering the Commission’s investor
protection mandate, and to consider
whether the costs imposed by the
current regulatory system for smaller
companies are proportionate to the
benefits, identify methods of
minimizing costs and maximizing
benefits and facilitate capital formation
by smaller companies. The language of
our Charter specified that we should
consider providing recommendations as
to where and how the Commission
should draw lines to scale regulatory
treatment for companies based on size.
Our chartering documents 3 purposely
did not define the phrase ‘‘smaller
public company.’’ Rather, it was
intended that we recommend how the
term should be defined. In addition, we
were advised that we were charged with
assessing the securities regulatory
system for all smaller companies, both
public and private, and were not limited
to considering regulations applicable to
public companies. The Commissioners
and the SEC staff did advise us,
however, that they hoped we would
focus primarily on public companies,
because of the apparent need for prompt
attention to that area of concern,
especially in view of problems in
implementing the Sarbanes-Oxley Act of
2002.
2 Pub. L. No. 107–204, 116 Stat. 745 (July 30,
2002).
3 The official notice of establishment of the
Committee and its Charter, included in this report
as Appendices A and B, respectively, constitute our
chartering documents.
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Our 21 members voted unanimously
on April 20, 2006 to adopt this Final
Report and transmit it to the
Commission. The recommendations set
forth in this report were for the most
part adopted unanimously. Where one
or more members dissented or, while
present, abstained from voting with
respect to a specific recommendation,
that fact has been noted in the text.
Additionally, Parts VII, VIII and IX of
this report contains separate statements
submitted by Mark Jensen, Kurt Schacht
and John B. Veihmeyer that describe
briefly their reasons for disagreeing with
specific recommendations of the
majority of our voting members.
Recommendations
Our final recommendations are
discussed in the remainder of this
report. Before summarizing our highest
priority recommendations below, we
would like to explain why we have
presented them in the order that we
have. As detailed under the caption
‘‘Part I—Committee History—Committee
Activities,’’ we conducted most of our
preliminary deliberations in four
subcommittees, and a ‘‘size task force’’
comprised of a representative of each
subcommittee and Committee Co-Chair
James C. Thyen, who chaired the size
task force. The subcommittees and the
size task force generated preliminary
recommendations that were discussed
and approved by the full Committee. We
agreed at our meeting on April 20, 2006
to submit to the Commission the 32
final recommendations contained in this
report.4
We recognize that it is unlikely that
the Commission and its staff will be able
to consider, much less act upon, all 32
of these recommendations at once.
Furthermore, submitting such a large
number of recommendations, without
any indication of the importance or
priority we ascribe to them, might make
the Commission less likely to act upon
recommendations in areas where we
believe the need for action is most
urgent. Accordingly, we have adopted a
two-tiered approach towards the
prioritization of our recommendations.
The first tier—the recommendations
to which we assign the highest
priority—we refer to as our ‘‘primary
recommendations.’’ Our primary
recommendations are set forth under the
specific topic to which they relate: Our
recommendation concerning
establishment of a scaled securities
regulation system is discussed under the
caption ‘‘Part II. Scaling Securities
Regulation for Smaller Companies’’;
recommendations related to internal
control over financial reporting are
discussed under the caption ‘‘Part III.
Internal Control Over Financial
Reporting’’; capital formation, corporate
governance and disclosure
recommendations are discussed under
the caption ‘‘Part IV. Capital Formation,
Corporate Governance and Disclosure’’;
and accounting standards
recommendations are discussed under
the caption ‘‘Part V. Accounting
Standards.’’
Before addressing our
recommendations, the Committee
wishes to emphasize that each of our
members fully embraces the concepts of
good governance and transparency. We
believe our recommendations are
designed to further these goals while
establishing cost effective methods of
achieving them.
Our first primary recommendation
concerns establishment of a new system
of scaled or proportional securities
regulation for smaller public companies
based on a stratification of smaller
public companies into two groups,
microcap companies and smallcap
companies. Under this
recommendation, microcap companies
would consist of companies whose
outstanding common stock (or
equivalent) in the aggregate comprises
the lowest 1% of total U.S. equity
market capitalization, and smallcap
companies would consist of companies
whose outstanding common stock (or
equivalent) in the aggregate comprises
the next lowest 5% of total U.S. equity
market capitalization. Smaller public
companies, consisting of microcap and
smallcap companies, would thus in the
aggregate comprise the lowest 6% of
total U.S. equity market capitalization.
While they account for only a small
percentage of total U.S. equity market
capitalization, these companies
represent a substantial percentage of all
U.S. public companies, as shown in the
table below:
Market capitalization cutoff
(million)
Microcap Companies .......................................................................................................
Smallcap Companies .......................................................................................................
Smaller Public Companies ..............................................................................................
Larger Public Companies ................................................................................................
Percentage of
total U.S. equity
market
capitalization
Percentage of all
U.S. public
companies
1
5
6
94
52.6
25.9
78.5
21.5
$128.2
128.2–787.1
<787.1
>787.1
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Source: SEC Office of Economic Analysis, Background Statistics: Market Capitalization and Revenue of Public Companies, Table 2 (Aug. 2,
2005) (included as Appendix I). Table includes only the 9,428 U.S. companies listed on the New York and American Stock Exchanges, the
NASDAQ Stock Market and the OTC Bulletin Board, with a total market capitalization of $16,891 million as of June 10, 2005. Table does not include the approximately 4,586 securities of 4,504 U.S. public companies whose stock trades only on the Pink Sheets, a number of which are not
required to file annual and quarterly reports with the SEC in accordance with either Section 13 or 15(d) of the Securities Exchange Act of 1934
and accordingly do not fall within the definition of ‘‘public company’’ as used in this report. The omission of data concerning Pink Sheets companies understates the percentage of U.S. public companies represented by microcap companies. See Appendix J.
We believe that the Commission
should establish this scaled system
before or in connection with proceeding
to examine individual securities
regulations to determine whether they
are candidates for integration of scaling
treatment under the new system.
Because of its significance, we felt that
this recommendation merited
discussion under a separate caption.
Accordingly, we discuss this
recommendation and our thoughts
about implementing in this approach
‘‘Part II. Scaling Securities Regulation
for Smaller Companies.’’
Below is a list of our remaining
primary recommendations, and the
4 This does not include two recommendations,
which the Committee adopted on August 10, 2005
and submitted to the Commission in a separate
report dated August 18, 2005 (included as
Appendix L of this report and discussed therein).
The Commission acted favorably upon these two
recommendations in September 2005. See Revisions
to Accelerated Filer Definition and Accelerated
Deadlines for Filing Periodic Reports, SEC Release
No. 33–8617 (Sept. 22, 2005); Management’s Report
on Internal Over Financial Reporting and
Certification of Disclosure in Exchange Act Reports
of Companies that are Not Accelerated Filers, SEC
Release No. 33–8618 (Sept. 22, 2005).
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location in this report where they are
described in greater detail: 5
• Establish a new system of scaled or
proportional securities regulation for
smaller public companies using the
following six determinants to define a
‘‘smaller public company’’:
I The total market capitalization of
the company;
I A measurement metric that
facilitates scaling of regulation;
I A measurement metric that is selfcalibrating;
I A standardized measurement and
methodology for computing market
capitalization;
I A date for determining total market
capitalization; and
I Clear and firm transition rules, i.e.,
small to large and large to small
(Recommendation II.P.1).
Develop specific scaled or
proportional regulation for companies
under the system if they qualify as
‘‘microcap companies’’ because their
equity market capitalization places them
in the lowest 1% of total U.S. equity
market capitalization or as ‘‘smallcap
companies’’ because their equity market
capitalization places them in the next
lowest 1% to 5% of total U.S. equity
market capitalization, with the result
that all companies comprising the
lowest 6% would be considered for
scaled or proportional regulation.
• Unless and until a framework for
assessing internal control over financial
reporting for microcap companies is
developed that recognizes the
characteristics and needs of those
companies, provide exemptive relief
from the requirements of Section 404 of
the Sarbanes-Oxley Act 6 to microcap
companies with less than $125 million
in annual revenue and to smallcap
companies with less than $10 million in
annual product revenue that have or
expand their corporate governance
controls to include:
I Adherence to standards relating to
audit committees in conformity with
Rule 10A–3 under the Securities
Exchange Act of 1934; 7 and
• Adoption of a code of ethics within
the meaning of Item 406 of Regulation
S–K 8 applicable to all directors, officers
and employees and compliance with the
further obligations under Item 406(c)
5 We have labeled our recommendations by
section in which their full description appears,
status (either primary (P) or secondary (S)), and
rank within a given section. Hence the first primary
recommendation in Part III is Recommendation
III.P.1; the third secondary recommendation in Part
IV is Recommendation IV.S.3, etc.
6 15 U.S.C. 7262.
7 15 U.S.C. 78a et seq.
8 17 CFR 229.
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relating to the disclosure of the code of
ethics.
In addition, as part of this
recommendation, we recommend that
the Commission confirm, and if
necessary clarify, the application to all
microcap companies, and indeed to all
smallcap companies also, the existing
general legal requirements regarding
internal controls, including the
requirement that companies maintain a
system of effective internal control over
financial reporting, disclose
modifications to internal control over
financial reporting and their material
consequences, and apply CEO and CFO
certifications to such disclosures.
Moreover, management should be
required to report on any known
material weaknesses. In this regard, the
Proposed Statement on Auditing
Standards of the AICPA,
‘‘Communications of Internal Control
Related Matters Noted in an Audit,’’ if
adopted by the AICPA and the Public
Company Accounting Oversight Board
(PCAOB), would strengthen this
disclosure requirement and provide
some external auditor involvement in
the internal control over financial
reporting process. (Recommendation
III.P.1).
• Unless and until a framework for
assessing internal control over financial
reporting for smallcap companies is
developed that recognizes the
characteristics and needs of those
companies, provide exemptive relief
from external auditor involvement in
the Section 404 process to smallcap
companies with less than $250 million
but greater than $10 million in annual
product revenues, subject to their
compliance with the same corporate
governance standards detailed in the
recommendation above
(Recommendation III.P.2).
• While we believe that the costs of
the requirement for an external audit of
the effectiveness of internal control over
financial reporting are disproportionate
to the benefits, and have therefore
adopted the second Section 404
recommendation above, we also believe
that if the Commission reaches a public
policy conclusion that an audit
requirement is required, we recommend
that changes be made to the
requirements for implementing Section
404’s external auditor requirement to a
cost-effective standard, which we call
‘‘ASX,’’ providing for an external audit
of the design and implementation of
internal controls (Recommendation
III.P.3).
• Incorporate the scaled disclosure
accommodations currently available to
small business issuers under Regulation
S–B into Regulation S–K, make them
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available to all microcap companies,
and cease prescribing separate
specialized disclosure forms for smaller
companies (Recommendation IV.P.1).
• Incorporate the primary scaled
financial statement accommodations
currently available to small business
issuers under Regulation S–B into
Regulation S–K or Regulation S–X and
make them available to all microcap and
smallcap companies (Recommendation
IV.P.2).
• Allow all reporting companies
listed on a national securities exchange,
NASDAQ or the OTC Bulletin Board to
be eligible to use Form S–3, if they have
been reporting under the Exchange Act
for at least one year and are current in
their reporting at the time of filing
(Recommendation IV.P.3).
• Adopt policies that encourage and
promote the dissemination of research
on smaller public companies
(Recommendation IV.P.4).
• Adopt a new private offering
exemption from the registration
requirements of the Securities Act of
1933 (the ‘‘Securities Act’’) 9 that does
not prohibit general solicitation and
advertising for transactions with
purchasers who do not need all the
protections of the Securities Act’s
registration requirements. Additionally,
relax prohibitions against general
solicitation and advertising found in
Rule 502(c) under the Securities Act to
parallel the ‘‘test the waters’’ model of
Rule 254 under that Act
(Recommendation IV.P.5).
• Spearhead a multi-agency effort to
create a streamlined NASD registration
process for finders, M&A advisors and
institutional private placement
practitioners (Recommendation IV.P.6).
• Develop a ‘‘safe-harbor’’ protocol
for accounting for transactions that
would protect well-intentioned
preparers from regulatory or legal action
when the process is appropriately
followed (Recommendation V.P.1).
• In implementing new accounting
standards, the FASB should permit
microcap companies to apply the same
extended effective dates that it provides
for private companies (Recommendation
V.P.2).
• Consider additional guidance for all
public companies with respect to
materiality related to previously issued
financial statements (Recommendation
V.P.3).
• Implement a de minimis provision
in the application of the SEC’s auditor
independence rules (Recommendation
V.P.4).
Our second tier consists of all of the
remaining recommendations, which we
9 15
U.S.C. 77a et seq.
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refer to in this report as ‘‘secondary
recommendations.’’ Although we have
assigned these a lower priority than the
recommendations set forth above, we do
not in any way intend to diminish their
importance. In this regard, we note that
importance is at times not only a
function of the perceived need for
change but also the perceived ease with
which the Commission could enact such
change; as noted throughout the report,
many problems simply defy easy
solution. Moreover, several of these
recommendations are aspirational in
nature, and do not involve specific
Commission action. As with the primary
recommendations, these secondary
recommendations are set forth under the
specific topics to which they relate, and
within each such section,
recommendations are presented in
descending order of importance (i.e., the
secondary recommendation that we
would most like to see adopted is listed
first, etc.).
Part I. Committee History
On December 16, 2004, then SEC
Chairman William H. Donaldson
announced the Commission’s intent to
establish the SEC Advisory Committee
on Smaller Public Companies.10 At the
same time, Chairman Donaldson
announced his intention to name
Herbert S. Wander and James C. Thyen
as Co-Chairs of the Committee. The
official notice of our establishment was
published in the Federal Register five
days later.11 The Committee’s
membership was completed on March 7,
2005, with members drawn from a wide
range of professions, backgrounds and
experiences.12 The Committee’s Charter
was filed with the Senate Committee on
Banking, Housing and Urban Affairs and
the House Committee on Financial
Services on March 23, 2005, initiating
our 13-month existence.13
Committee Activities
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We held our organizational meeting
on April 12, 2005 in Washington, DC,
where Chairman Donaldson swore in
and addressed our members. Also at
that meeting, we adopted our by-laws,
10 SEC Establishes Advisory Committee to
Examine Impact of Sarbanes-Oxley Act on Smaller
Public Companies, SEC Press Release No. 2004–174
(Dec. 16, 2004) (included as Appendix D).
11 Advisory Committee on Smaller Public
Companies, SEC Release No. 33–8514 (Dec. 21,
2004) [69 FR 76498] (included as Appendix B).
12 SEC Chairman Donaldson Announces Members
of Advisory Committee on Smaller Public
Companies, SEC Press Release No. 2005–30 (Mar.
7, 2005) (included as Appendix E). This press
release describes the diverse backgrounds of the
Committee members.
13 See Committee Charter (included as Appendix
B).
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proposed a Committee Agenda to be
published for public comment 14 and
reviewed a subcommittee structure and
Master Schedule prepared by our CoChairs. This and all of our subsequent
meetings were open to the public and
conducted in accordance with the
requirements of the Federal Advisory
Committee Act.15 All meetings of the
full Committee also were Web cast over
the Internet.
Shortly following our formation, we
adopted several overarching principles
to guide our efforts:
• Further Commission’s investor
protection mandate.
• Seek cost choice/benefit inputs.
• Keep it simple.
• Maintain culture of
entrepreneurship.
• Capital formation should be
encouraged.
• Recommendations should be
prioritized.
We held subsequent meetings in 2005
on June 16 and 17 in New York City,
August 9 and 10 in Chicago, September
19 and 20 in San Francisco, and October
14 again in New York City. A total of 42
witnesses testified at these meetings.16
We adopted our Committee Agenda at
the June 16 meeting in New York.17 We
adopted two recommendations to the
Commission at our Chicago meeting,
where we also adopted an internal
working definition of the term ‘‘smaller
public company.’’ 18 We held additional
meetings in Washington on October 24
and 25 and December 14, 2005 and
February 21, 2006 to consider and vote
on recommendations and the draft of
our final report to the Commission. SEC
Chairman Christopher Cox, who had
succeeded Chairman Donaldson on
14 The Record of Proceedings of this and
subsequent meetings of the Committee are available
on our Web site at https://www.sec.gov/info/
smallbus/ascpc.shtml. See Record of Proceedings,
Meeting of the Securities and Exchange
Commission Advisory Committee on Smaller Public
Companies (Apr. 12, June 16, June 17, Aug. 9, Aug.
10, Sept. 19, Sept. 20, Oct. 24, Oct. 25 & Dec. 14,
2005 & Feb. 21, Apr. 11 & Apr. 20, 2006) (on file
in SEC Public Reference Room File No. 265–23),
available at https://www.sec.gov/info/smallbus/
ascpc.shtml (hereinafter Record of Proceedings
(with appropriate date)).
15 5 U.S.C.—App. 1 et seq.
16 Appendix K contains a list of witnesses who
testified before the Committee.
17 The Committee Agenda is included as
Appendix C.
18 The Chicago recommendations were submitted
to the Commission by letter dated August 18, 2005
to SEC Chairman Christopher Cox, who had
succeeded Chairman Donaldson. The text of the
letter is included as Appendix L. The letter
included copies of documents entitled ‘‘Six
Determinants of a Smaller Public Company’’ and
‘‘Definition of Smaller Public Company,’’ which
had been made available to the Committee before
it adopted its definition of the term ‘‘smaller public
company.’’
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August 3, 2005, addressed us at the
October 24 meeting in Washington. No
witnesses testified at the additional
meetings in Washington.
The Committee, through the
Commission, published three releases in
the Federal Register formally seeking
public comment on issues it was
considering. On April 29, 2005, we
published a release seeking comments
on our proposed Committee Agenda,19
in response to which we received ll
written submissions. On August 2, 2005,
we published 29 questions on which we
sought public input, to which we
received 266 responses.20 Finally, on
llllll, 2006, we published an
exposure draft of our final report,21
which generated ll written
submissions. In addition, each meeting
of the Committee was announced by
formal notice in a Federal Register
release, and each such notice included
an invitation to submit written
statements to be considered in
connection with the meeting. In total,
we received ll written statements in
response to Federal Register releases.22
In addition to work carried out by the
full Committee, fact finding and
deliberations also took place within four
subcommittees appointed by our CoChairs. The subcommittees were
organized according to their principal
areas of focus: Accounting Standards,
Capital Formation, Corporate
Governance and Disclosure, and
Internal Control Over Financial
Reporting. Each of the subcommittees
prepared recommendations for
consideration by the full Committee. We
approved preliminary versions of most
recommendations at our December 14,
2005 meeting. A fifth subgroup,
sometimes referred to as the ‘‘size task
force’’ in our deliberations, consisted of
one volunteer from each subcommittee
and our Co-Chair James C. Thyen. The
size task force met to consider common
issues faced by the subcommittees
relating to establishment of parameters
for eventual recommendations on
19 Summary of Proposed Committee Agenda of
Advisory Committee on Smaller Public Companies,
SEC Release No. 33–8571, (Apr. 29, 2005) [70 FR
22378].
20 See Request for Public Input by Advisory
Committee on Smaller Public Companies, SEC
Release No. 33–8599 (Aug. 5, 2005) [70 FR 45446]
(included as Appendix H).
21 llllllll, SEC Release No. 33–ll
(2006).
22 All of the written submissions made to the
Committee are available in the SEC’s Public
Reference Room in File No. 265–23 and on the
Committee’s Web page at https://www.sec.gov/rules/
other/265-23.shtml. To avoid duplicative material
in footnotes, citations to the written submissions
made to the Committee in this Final Report do not
reference the Public Reference Room or repeat the
Public Reference Room file number.
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scalability of regulations based on
company size. The task force developed
internal working guidelines for the
subcommittees to use for this purpose
and reported them to the full Committee
at our August 10, 2005 meeting.23 We
voted to approve the guidelines, which
are discussed in the next part of this
report.
Part II. Scaling Securities Regulation
for Smaller Companies
We developed a number of
recommendations concerning the
Commission’s overall policies relating
to the scaling of securities regulation for
smaller public companies. As discussed
below, we believe that these
recommendations are fully consistent
with the original intent and purpose of
our Nation’s securities laws.24 We
believe that, over the years, some of the
original principles underlying our
securities laws, including
proportionality, have been
underemphasized, and that the
Commission should seek to restore
balance in these areas where
appropriate.
Our primary recommendation
concerning scaling, and one that
underlies several other
recommendations that follow in this
report, is as follows:
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Recommendation II.P.1
Establish a new system of scaled or
proportional securities regulation for
smaller public companies using the
following six determinants to define a
‘‘smaller public company’’:
The total market capitalization of the
company;
I A measurement metric that
facilitates scaling of regulation;
I A measurement metric that is selfcalibrating;
I A standardized measurement and
methodology for computing market
capitalization;
I A date for determining total market
capitalization; and
I Clear and firm transition rules, i.e.,
small to large and large to small.
Develop specific scaled or
proportional regulation for companies
under the system if they qualify as
‘‘microcap companies’’ because their
equity market capitalization places them
in the lowest 1% of total U.S. equity
market capitalization or as ‘‘smallcap
companies’’ because their equity market
capitalization places them in the next
23 See Record of Proceedings 62–103 (Aug. 10,
2005).
24 For background on the history of scaling federal
securities regulation for smaller companies, see the
discussion under the caption ‘‘—Commission Has a
Long History of Scaling Regulation’’ below.
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lowest 1% to 5% of total U.S. equity
market capitalization, with the result
that all companies comprising the
lowest 6% would be considered for
scaled or proportional regulation.25
This new system would replace the
SEC’s current scaling system for ‘‘small
business issuers’’ eligible to use
Regulation S–B 26 as well as the current
scaling system based on ‘‘nonaccelerated filer’’ status,27 but would
provide eligibility for scaled regulation
for companies based on their size
relative to larger companies.28
Under our recommended system,
companies would be eligible for special
scaled or proportional regulation if they
fall into one of two categories of smaller
public companies based on size. We call
one category ‘‘microcap companies’’ and
the other ‘‘smallcap companies.’’ Both
categories of companies would be
included in the category of ‘‘smaller
public companies’’ that qualify for the
new scaled regulatory system.
Companies whose common stock (or
equivalent) in the aggregate comprises
the lowest 1% of total U.S. equity
market capitalization (companies with
equity capitalizations below
approximately $128 million 29) would
qualify as microcap companies.
Companies whose common stock (or
equivalent) in the aggregate comprises
the next lowest 5% of total U.S. equity
market capitalization (companies with
equity capitalizations between
approximately $128 million and $787
million) generally would qualify as
smallcap companies.30 Smallcap
25 Mr. Schacht abstained from voting on this
recommendation. All other members present voted
in favor of this recommendation.
26 Regulation S–B can be found at 17 CFR 228.
27 ‘‘Non-accelerated filers’’ are public companies
that do not qualify as ‘‘accelerated filers’’ under the
SEC’s definition of the latter term in 17 CFR
240.12b–2, generally because they have a public
float of less than $75 million. Companies that do
not qualify as accelerated filers have more time to
file their annual and quarterly reports with the SEC
and have not yet been required to comply with the
internal control over financial reporting
requirements of Sarbanes-Oxley Act Section 404.
28 We believe our recommended system
complements the SEC’s recently promulgated
securities offering reforms, which are principally
available to a category of public companies with
over $700 million in public float known as ‘‘wellknown seasoned issuers.’’ We recognize, however,
that the Commission will need to assure that our
recommendations, if adopted, are integrated well
with the categories of companies established in the
securities offering reform initiatives.
29 SEC Office of Economic Analysis, Background
Statistics: Market Capitalization and Revenue of
Public Companies (Aug. 2, 2005) (included as
Appendix I). Data was derived from Center for
Research in Security Prices (CRSP) for 9,428 New
York and American Stock Exchange companies as
of March 31, 2005 and from NASDAQ for NASDAQ
Stock Market and OTC Bulletin Board firms as of
June 10, 2005.
30 Id.
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companies would be entitled to the
regulatory scaling provided by SEC
regulations for companies of that size
after study of their characteristics and
special needs.
Under the system we are
recommending, microcap companies
generally would be entitled to the
accommodations afforded to small
business issuers and non-accelerated
filers under the SEC’s current rules.
Smallcap companies would be entitled
to whatever accommodations the SEC
decides to provide them in the future.
As discussed below, we are
recommending that the SEC provide
certain relief under Sarbanes-Oxley Act
Section 404 to certain smaller public
companies.31 We also are
recommending that the SEC permit
smaller public companies to follow the
financial statement rules now followed
by small business issuers under Item
310 of Regulation S–B rather than the
financial statement rules in Regulation
S–X currently followed by all
companies that are not small business
issuers.32
Our primary reason for
recommending special scaled regulation
for companies falling in the aggregate in
the lowest 6% of total U.S. equity
market capitalization is that this cutoff
assures the full benefits and protection
of federal securities regulation for
companies and investors in 94% of the
total public U.S. equity capital
markets.33 This limits risk and exposure
to investors and protects investors from
serious losses (e.g., 100 bankruptcies
companies with $10 million total
market capitalization would be required
to equal the potential loss of the
bankruptcy of a company with $1
billion of market capitalization). Our
recommended standard acknowledges
the relative risk to investors and the
capital markets as it is currently used by
professional investors.
In addition, we considered the SEC’s
recent adoption of rules reforming the
31 See
the discussion in Part III below.
the discussion in Part IV below.
33 We recognize that, if the Commission
determines to implement our recommendation, it
may want to examine the distinguishing
characteristics of the group of ‘‘smaller public
companies’’ to which it intends to provide specific
regulatory relief. We have done this in developing
our recommendations set out in ‘‘Part III. Internal
Control Over Financial Reporting.’’ A comment
letter recently sent to the Commission also went
through this exercise in making recommendations
with respect to application of Section 404 of the
Sarbanes-Oxley Act to smaller public companies.
See Letter from BDO Seidman, LLP, at 2–3 (Oct. 31,
2005) (on file in SEC Public Reference Room File
No. S7–06–03), available at https://www.sec.gov/
rules/proposed/s70603/bdoseidman103105.pdf.
32 See
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securities offering process.34 Reporting
companies with a public float of $700
million or more, called ‘‘well-known
seasoned issuers,’’ generally will be
permitted to benefit to the greatest
degree from securities offering reform.
We are hopeful that the Commission
will see fit to adopt a disclosure system
applicable to ‘‘smaller public
companies’’ that integrates well with the
disclosure and other rules applicable to
‘‘well-known seasoned issuers.’’ We
believe that companies that qualify as
‘‘smaller public companies’’ on the basis
of equity market capitalization should
not also qualify as ‘‘well-known
seasoned issuers.’’
We recommend that the SEC
implement this recommendation by
promulgating regulations under which
all U.S. companies with equity
securities registered under the Exchange
Act would be ranked from largest to
smallest equity market capitalization at
each recalculation date.35 The ranges of
market capitalizations entitling public
companies to qualify as a ‘‘microcap
company’’ and ‘‘smallcap company’’
would be published soon after the
recalculation. These ranges would
remain valid until the next recalculation
date. Companies would be able to
determine whether they qualify for
microcap and smallcap company
treatment by comparing their market
capitalization on their determination
date, presumably the last day of their
previous fiscal year, with the ranges
published by the SEC for the most
recent recalculation date.36 The
determination so would then be used to
by companies to determine their status
for the next fiscal year. This is what we
mean when we say that the
measurement metric for determining
smaller public company status should
be ‘‘self-calibrating.’’
In promulgating these rules, the SEC
will need to establish clear transition
rules providing how companies would
graduate from the microcap category to
the smallcap category to the realm
where they would not be entitled to
smaller public company scaling. The
transition rules would also need to
34 See Securities Offering Reform, SEC Release
No. 33–8591 (July 19, 2005) [70 FR 44722].
35 We leave to the Commission’s discretion the
frequency with which this recalculation should
occur, but note that frequent recalculation, even on
an annual basis, could introduce an undesirable
level of uncertainty into the process for companies
trying to determine where they fall within the three
categories.
36 In formulating this recommendation, we looked
for guidance at the method used to calculate the
Russell U.S. Equity Indexes. For more information
on Russell’s method, see Russell U.S. Equity
Indexes, Construction and Methodology (July
2005)), available at www.russell.com.
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specify how companies would move
from one category to another in the
reverse order, from no scaling
entitlement to smallcap company
treatment to microcap entitlement. The
SEC has experience and precedents to
follow in its transition rules governing
movement to and from Regulation S–B
and Regulation S–K, non-accelerated
filer status and accelerated filer status,
and well-known seasoned issuer
eligibility and non-eligibility.
We believe that our plan for providing
scaled regulatory treatment for smaller
public companies contains features that
recommend it over some other SEC
regulatory formats. For example, it
provides for a flexible measurement that
can move up and down, depending on
stock price and other market levels. It
avoids the problem of setting a dollar
amount standard that needs to be
revisited and rewritten from time to
time, and consequently provides a longterm solution to the problem of rescaling securities regulation for smaller
public companies every few years.
Finally, assuming the plan is
implemented as we intend, the system
would provide full transparency and
allow each company and its investors to
determine the company’s status in
advance or at any time based on
publicly available information. This
would allow companies to plan for
transitions suitably in advance of
compliance with new regulations.
We recommend that the SEC use
equity market capitalization, rather than
public float, to determine eligibility for
smaller public company treatment for
several reasons.37 We are aware that the
SEC historically has used public float as
a measurement in analogous regulatory
contexts.38 However, we recommend
that the SEC use equity capitalization,
rather than public float, to determine
eligibility for smaller public companies
for several reasons. First, we believe that
equity market capitalization better
measures total risk to investors
(including affiliates, some of whom may
not have adequate access to
information) and the U.S. capital
markets than public float, and
consequently that it is the most relevant
measure in determining which
companies initially should qualify for
scaled securities regulatory treatment
based on size. We also believe that using
market capitalization has the additional
advantage of simplicity, as it avoids
what can be the difficult problem of
37 The Commission would, of course, need to
prescribe a standardized methodology for
computing market capitalization.
38 For example, a public float test is used to
determine a company’s eligibility to use Forms SB–
2, F–3 and S–3 and non-accelerated filer status.
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deciding for legal purposes which
holdings are public float and which are
not.39 This can be a subjective
determination; not all companies reach
the same conclusions on this issue
based on similar facts, which can lead
to problems of comparability.
In formulating our scaling
recommendation, we considered a
number of alternatives to market
capitalization as the primary metric for
determining eligibility for scaling,
including revenues. Ultimately,
however, we felt that any benefits to be
derived from adding additional metrics
to the primary formula were outweighed
by the additional complexity that
introduction of those additional size
parameters would entail. We wish to
make it clear, however, that we believe
that additional determinants based on
other metrics of size may be appropriate
in the context of individual securities
regulations. For example, our own
recommendations on internal control
over financial reporting contain metrics
conditioning the availability of scaling
treatment on company annual revenues.
Commission Has a Long History of
Scaling Regulation
Since federal securities regulation
began in the 1930’s, it has been
recognized that some companies and
transactions are of insufficient
magnitude to warrant full federal
regulation, or any federal regulation at
all. Smaller public companies primarily
have been subject to two securities
statutes, the Securities Act and the
Exchange Act. The Securities Act,
originally enacted to cover distributions
of securities, has from the beginning
contained a ‘‘small issue’’ exemption in
Section 3(b) 40 that gives the SEC
rulemaking authority to exempt any
securities issue up to a specified
maximum amount. This amount has
grown in stages, from $100,000 in 1933
to $5 million since late 1980.41 The
Exchange Act originally was enacted to
regulate post-distribution trading in
securities. It did so by requiring
registration by companies of classes of
39 Because public float by definition excludes
shares held by affiliates, calculation of public float
relies upon an accurate assessment of affiliate status
of officers, directors and shareholders. As the
Commission acknowledged in the Rule 144 context,
this requires a subjective, facts and circumstances
determination that entails a great deal of
uncertainty. See Revision of Rule 144, Rule 145 and
Form 144, SEC Release No. 33–7391 (Feb. 20, 1997)
[62 FR 9246].
40 15 U.S.C. 77c(b).
41 Louis Loss & Joel Seligman, Fundamentals of
Securities Regulation 387 (2004). The Commission
has adopted a number of exemptive measures for
small issuers pursuant to its authority under
Section 3(b), including Rules 504 and 505,
Regulation A and the original version of Rule 701.
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their securities. At first, the Exchange
Act required companies to register only
if their securities were traded on a
national securities exchange. This
assured that smaller companies of
insufficient size to warrant exchange
listing would not be subject to overly
burdensome federal securities
regulation.
In 1964, Congress extended the reach
of most of the Exchange Act’s public
company provisions to cover companies
whose securities trade over-thecounter.42 Since all securities other than
exchange-listed securities technically
trade ‘‘over-the-counter,’’ this expansion
required limiting the companies covered
to avoid creating a burden on issuers
and the Commission that was
‘‘unwarranted by the number of
investors protected, the size of
companies affected, and other factors
bearing on the public interest.’’ 43
Congress wanted to ensure that ‘‘the
flow of reports and proxy statements
[would] be manageable from the
regulatory standpoint and not
disproportionately burdensome on
issuers in relation to the national public
interest to be served.’’ 44 Accordingly,
Congress chose to limit coverage to
companies with a class of equity
security held of record by at least 500
persons and net assets above $1
million.45 Over time, the standard set by
Congress at 500 equity holders of record
and $1 million in net assets required
adjustment to assure that the burdens
placed on issuers and the Commission
were justified by the number of
investors protected, the size of
companies affected, and other factors
bearing on the public interest, as
originally intended by Congress. The
Commission has raised the minimum
net asset level several times; it now
stands at $10 million.46
In 1992, the Commission adopted
Regulation S–B,47 a major initiative that
allows companies qualifying as ‘‘small
business issuers’’ (currently, companies
with revenues and a public float of less
than $25 million 48) to use a set of
abbreviated disclosure rules scaled for
smaller companies. In 2002, the
Commission divided public companies
into two categories, ‘‘accelerated filers’’
42 Securities Acts Amendments of 1964, Pub. L.
No. 88–467, 78 Stat. 565 (adding Section 12(g),
among other provisions, to the Exchange Act).
43 S. Rep. No. 88–379, at 19 (1963).
44 Id.
45 15 U.S.C. 78l(g).
46 17 CFR 240.12g5–1.
47 17 CFR 228.10 et seq.
48 17 CFR 228.10(a)(1). ‘‘Small business issuers’’
must also be U.S. or Canadian companies, not
investment companies and not majority owned
subsidiaries of companies that are not small
business issuers.
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and ‘‘non-accelerated filers,’’ and in
2005 added a third category of ‘‘large
accelerated filers,’’ providing scaled
securities regulation for these three tiers
of reporting companies.49 Nonaccelerated filers are fundamentally
public companies with a public float
below $75 million, and large accelerated
filers are public companies with a
public float of $700 million or more.50
Notwithstanding the benefits to which
smaller business issuers and nonaccelerated filers are entitled under the
Commission’s current rules, we believe
significant changes to the federal
securities regulatory system for smaller
public companies, such as those
recommended in this report, are
required to assure that it is properly
scaled for smaller public companies.
Our experience with smaller public
companies, as well as the testimony and
written statements we received, support
this view. We believe that the problem
of improper scaling for smaller public
companies has existed for many years,
and that the additional regulations
imposed by the Sarbanes-Oxley Act
only exacerbated the problem and
caused it to become more visible.
Part III. Internal Control Over
Financial Reporting
Introduction
From the earliest stages of its
implementation, Sarbanes-Oxley Act
Section 404 has posed special
challenges for smaller public
companies. To some extent, the
problems smaller companies have in
complying with Section 404 are the
problems of companies generally:
• Lack of clear guidance;
• An unfamiliar regulatory
environment;
• An unfriendly legal and
enforcement atmosphere that
diminishes the use and acceptance of
professional judgment because of fears
of second-guessing by regulators and the
plaintiff’s bar; 51
• A focus on detailed control
activities by auditors; and
49 See Acceleration of Periodic Report Filing
Dates and Disclosure Concerning Web site Access
to Report, SEC Release No. 33–8128 (Sept. 16, 2002)
[67 FR 58480].
50 17 CFR 240.12b–2. Both accelerated filers and
large accelerated filers must also have been
reporting for at least 12 months, have filed at least
one annual report and not be eligible to use Forms
10–KSB and 10–QSB.
51 See Conference Panelists Discuss Earnings
Guidance and Accounting Issues, SEC Today (Feb.
14, 2006), at 2 (quoting Teresa Iannaconi as stating
that while she believes the PCAOB is sincere in its
attempt to bring greater efficiency to the audit
process, accounting firms are not ready to step back,
because they have all received deficiency letters,
none of which say that the auditors should be doing
less rather than more).
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• The lack of sufficient resources and
competencies in an area in which
companies and auditors have previously
placed less emphasis.
But because of their different
operating structures, smaller public
companies have felt the effects of
Section 404 in a manner different from
their larger counterparts. With more
limited resources, fewer internal
personnel and less revenue with which
to offset both implementation costs and
the disproportionate fixed costs of
Section 404 compliance, these
companies have been disproportionately
subject to the burdens associated with
Section 404 compliance. Moreover, the
benefits of documenting,52 testing and
certifying the adequacy of internal
controls, while of obvious importance
for large multinational corporations, are
of less certain value for smaller public
companies, who rely to a greater degree
on ‘‘tone at the top’’ and high-level
monitoring controls, which may be
undocumented and untested, to
influence accurate financial reporting.
The result is a cost/benefit equation
that, many believe, diminishes
shareholder value, makes smaller public
companies less attractive as investment
opportunities and impedes their ability
to compete.
This last factor is particularly
problematic in light of the crucial role
smaller public companies play in job
creation and economic growth. In
addition, we are increasingly
participating in a global economy and
(1) the much higher costs for SarbanesOxley compliance in general, and
Section 404 compliance in particular,
(2) the loss of foreign issuers who are
either not listing in the U.S. or are
departing from U.S. markets and (3)
domestic issuers who are going dark or
private could pose significant
competitive risks to U.S. companies and
markets.53
52 SEC rules require that a company maintain
evidential matter, including documentation, to
provide reasonable support for management’s
assessment of the effectiveness of the company’s
internal control over financial reporting. See
Section II.B. of Management’s Reports on Internal
Control Over Financial Reporting and Certification
of Disclosure in Exchange Act Periodic Reports,
SEC Release No. 33–8238 (June 5, 2003) [68 FR
36636]. See note 58 infra.
53 See William J. Carney, The Costs of Being
Public After Sarbanes-Oxley: The Irony of ‘Going
Private,’ Emory Law and Economics Research Paper
No. 05–4 at 1 (Feb. 2005), available at SSRN:
https://ssrn.com/abstract=672761 (‘‘In an
economically rational world we don’t want to
prevent all fraud, because that would be too
expensive. Instead, the goal should be to keep on
spending on fraud prevention until the returns on
a dollar invested in prevention are no more than a
dollar. There is an ‘Optimal Amount of Fraud.’ ’’);
Roberta Romano, The Sarbanes-Oxley Act and the
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We acknowledge that in the course of
our deliberations we heard certain
respected persons question whether the
Section 404 problem for smaller public
companies is, in fact, overstated.54 In
the view of some, the benefits of Section
404 for small companies outweigh the
costs, authoritative guidance for smaller
public companies will provide issuers
with sufficient guidance in areas where
clarity is currently lacking, and at any
rate Section 404 expenditures will
decrease substantially as issuers and
their auditors become more familiar
with the law’s requirements. However,
the experience of most of our members,
and the outpouring of testimony,
comment letters and input we received,
suggests otherwise.
After thorough consideration of the
evidence presented, we believe that
Section 404 represents a clear problem
for smaller public companies and their
investors, one for which relief is
urgently needed. Our recommendations
as to how to improve the existing
structure, consistent with investor
protections, are discussed below.
Although these recommendations are
based upon 13 months of intensive
study and debate, they essentially
derive from a few fundamental ideas:
the primary objective of internal control
over financial reporting requirements
should be the prevention of materially
inaccurate financial statements;
companies operate differently,
depending on size, and internal control
rules should reflect this fact; and the
benefits of any regulatory burden—
Section 404-related or otherwise—
should outweigh the costs.
Making of Quack Corporate Governance, 114 Yale
L. J. 1521, 1587–91 (2005); Joseph A. Grundfest,
Fixing 404 (2005) (unpublished manuscript, on file
in SEC Public Reference Room File No. 265–23)
(‘‘While there is substantial debate over the costs
and benefits of Section 404 as implemented by
PCAOB Statement No. 2, there is far greater
consensus that these rules are not cost effective. Put
another way, regardless of whether Section 404’s
social benefits exceed its social costs, a very large
portion of Section 404’s benefits can be generated
while imposing substantially lower costs on the
economy. Consistent with this view, the current
head of the PCAOB states ‘It is * * * clear to us
that the first sound of internal control audits cost
too much.’ ’’) Moreover, Congress, in the form of
Securities Act Section 2(b), has mandated that
whenever the SEC engages in rulemaking it is
required to consider in addition to the protection
of investors, whether the action will promote
efficiency, competition and capital formation. See
Peter J. Wallison, Buried Treasure: A Court
Rediscovers A Congressional Mandate the SEC Has
Ignored, AEI Online (Oct. 2005) available at https://
www.aei.org/publications/pubID.23310/
pub_detail.asp. See also infra notes 87 through 90
and accompanying text.
54 See, e.g., Record of Proceedings 64 (Sept. 19,
2005) (testimony of Lynn E. Turner), available at
https://www.sec.gov/info/smallbus/acspc/
acspctranscript091905.pdf.
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Because an appreciation of the
existing Section 404 problem requires
an understanding of the problem’s
origin, we have included below a brief
background section, followed by an
overview of our recommendations and
the recommendations themselves.
Background of Section 404
Sarbanes-Oxley Act Section 404
directed the SEC to adopt rules
requiring all reporting companies, other
than registered investment companies,
to include in their annual reports a
statement of management’s
responsibility for establishing and
maintaining adequate internal control
over financial reporting, together with
an assessment of the effectiveness of
those internal controls. Section 404
further required that the company’s
independent auditors attest to, and
report on, this management assessment.
In accordance with Congress’
directive, on June 5, 2003 the
Commission adopted the basic rules
implementing Section 404 with regard
to management’s obligations to report
on internal control over financial
reporting.55 In addition, on June 17,
2004 the Commission issued an order
approving PCAOB Auditing Standard
No. 2, entitled An Audit of Internal
Control over Financial Reporting
Performed in Conjunction with an Audit
of the Financial Statements (AS2),
which established the requirements that
apply to an independent auditor when
performing an audit of a company’s
internal control over financial
reporting.56 The rules adopted by the
Commission and the PCAOB
implementing Section 404 require
management to base its evaluation of
internal control over financial reporting
on a suitable, recognized control
framework that is established by a body
or group that has followed due-process
procedures, including the broad
distribution of the framework for public
comment.57 Commission rules
implementing both Section 404 and AS2
specifically identify the internal control
framework published by the Committee
of Sponsoring Organizations of the
Treadway Commission (COSO) (the
COSO Framework) as suitable for such
purposes, and indeed, the COSO
Framework has emerged as the only
internal control framework available in
55 SEC Release No. 33–8238 (June 5, 2003) [68 FR
36636].
56 SEC Release No. 34–49884 (June 17, 2004) [69
FR 35083].
57 See Exchange Act Rules 13a–15(c) and 15d–
15(c), 17 CFR 240.13a–15(c) & 240.15d–15(c).
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the U.S. and the framework used by
virtually all U.S. companies.58
As noted above, during the early
stages of implementation of Section 404,
it became clear that smaller public
companies, due to their size and
structure, were experiencing significant
challenges, both in implementing that
provision’s requirements and in
applying the SEC and PCAOB-endorsed
COSO Framework. Many expressed
serious concerns about the ability to
apply Section 404 to smaller public
companies in a cost-effective manner,
and also about the need for additional
guidance for smaller businesses in
applying the COSO Framework. Against
this backdrop, and at the encouragement
of the SEC staff, COSO in October 2005
issued for public comment an exposure
draft entitled ‘‘Guidance for Smaller
Public Companies Reporting on Internal
Control over Financial Reporting.’’ 59
While intended to provide much needed
clarity, the guidance has to date
received mixed reviews, with many
questioning whether it will significantly
change the disproportionate cost and
other burdens or the cost/benefit
equation associated with Section 404
compliance for smaller public
companies.60
58 COSO is a voluntary private sector organization
sponsored by the American Institute of Certified
Public Accountants (AICPA), the American
Accounting Association, Financial Executives
International, the Institute of Internal Auditors, and
the Institute of Management Accountants. COSO
published the COSO Framework, formally titled
‘‘Internal Control—Integrated Framework, in 1992.
The COSO Framework is available at https://
www.coso.org/publications/
executive_summary_integrated_framework.htm.
The COSO Framework presents a common
definition of internal control and provides a
framework against which internal controls within a
company can be assessed and improved. Under the
COSO Framework, internal control over financial
reporting is defined as a process, effected by an
entity’s board of directors, management and other
personnel, designed to provide reasonable
assurance regarding the achievement of objectives
in the reliability of financial reporting. Internal
control over financial reporting includes five
interrelated components: Control environment, risk
assessment, control activities, information and
communication, and monitoring. The COSO
Framework recognizes that formal documentation is
not always necessary, and that informal and
undocumented controls, even when communicated
orally, can be highly effective. See COSO
Framework at 30, 73.
59 Available at https://www.ic.coso.org.
60 Several comment letters submitted to COSO in
respect of the guidance are illustrative, including
the following: Letter from PCAOB to COSO (Jan. 18,
2006) (‘‘[S]ome of the approaches and examples in
the draft may be inappropriate or impractical for the
smallest public companies. We recommend that
COSO reconsider whether there is additional, more
practical advice that COSO could give to such
companies.’’); Letter from Institute of Management
Accountants to COSO (Oct. 24, 2005) (‘‘The IMA is
unclear as to how this guidance, built on the
existing COSO Framework, tangibly reduces SOX
compliance costs for small businesses or businesses
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Reporting companies initially were to
be required to comply with the internal
control reporting provisions for the first
time in connection with their fiscal
years ending on or after June 15, 2004
(accelerated filers) 61 or April 15, 2005
(non-accelerated filers and foreign
private issuers). Recognizing the
importance of these provisions and the
time necessary to implement them
properly, on February 24, 2004 the
Commission extended these compliance
dates to fiscal years ending after
November 15, 2004 for accelerated filers
and July 15, 2005 for non-accelerated
filers and foreign private issuers.62
On March 2, 2005, the Commission
further extended the compliance dates
for non-accelerated filers and foreign
private issuers to fiscal years ending
after July 15, 2006.63 Additionally, due
to the continuing evaluation of the
impact of the Section 404 requirements
on smaller public companies by this
Committee, on September 21, 2005, the
Commission provided an additional
one-year extension of the compliance
deadline for non-accelerated (but not
larger foreign) filers to fiscal years
ending after July 15, 2007.64
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Unintended Consequences of Attempts
To Address Internal Controls
The legislative history of Section 404
makes clear that regulators and
members of Congress never anticipated
many of the challenges that Section 404
compliance has presented. Section 404
itself states that the auditor’s attestation
‘‘shall not be the subject of a separate
of any size.’’); Letter from Deloitte & Touche LLP
to COSO (Dec. 30, 2005 (‘‘We believe that many of
the examples in the exposure draft are too highlevel and generic and do not address the issues
faced by smaller public companies.’’); Letter from
Crowe Chizek and Company LLC to COSO (Dec. 29,
2005) (‘‘While the document will help smaller
companies, we do not believe that it will result in
substantial reduction in the cost of evaluating and
documenting the internal control process by
management, and on the cost to audit internal
controls by companies’ auditing firms.’’); Letter
from Ernst & Young LLP to COSO (Jan. 15, 2006)
(‘‘[A]lthough we believe the Guidance will be an
excellent implementation aid, we are less
convinced that it will significantly reduce the cost
of 404 implementation for smaller companies, at
least to the degree expected by some.’’). All such
comment letters are available at https://
www.ic.coso.org/coso/cosospc.nsf/
COSO%20Public%20Comments%20Document.pdf.
The Chairman of COSO made a presentation at our
San Francisco meeting and met informally with
members of our Internal Control Over Financial
Reporting Subcommittee.
61 The term ‘‘accelerated filer’’ is defined in Rule
12b–2, 17 CFR 240.12b–2, under the Exchange Act,
15 U.S.C. 78a et seq.
62 SEC Release No. 33–8392 (Feb. 24, 2004) [69 FR
9722].
63 SEC Release No. 33–8545 (Mar. 2, 2005) [70 FR
11528].
64 SEC Release No. 33–8545 (Sept. 22, 2005) [70
FR 11528].
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engagement.’’ 65 Moreover, the Senate
Committee Report that accompanied
Section 404 to the Senate floor included
the following language:
In requiring the registered public
accounting firm preparing the audit report to
attest to and report on management’s
assessment of internal controls, the
Committee does not intend that the auditor’s
evaluation be the subject of a separate
engagement or the basis for increased charges
or fees. High quality audits typically
incorporate extensive internal control testing.
The Committee intends that the auditor’s
assessment of the issuer’s system of internal
controls should be considered to be a core
responsibility of the auditor and an integral
part of the audit report.66
Additionally, the Commission’s June
2003 release adopting internal control
rules, which predated adoption and
approval of AS2, estimated that the
average annual internal cost of
compliance with Section 404 over the
first three years would be $91,000, and
that cost would be proportional relative
to the size of the company.67 The reality
has, of course, been much different.
The anxieties that Section 404 has
produced, and the heavy expenses that
have been incurred in an attempt to
comply with its requirements, parallel
those experienced as a result of
Congress’ last major initiative to address
internal accounting controls, the
Foreign Corrupt Practices Act of 1977,
or FCPA.68 That statute added two
accounting requirements applicable to
public companies under the Exchange
Act, including Section 13(b)(2)(B), the
provision that requires public
companies to devise and maintain a
system of internal accounting controls
sufficient to provide reasonable
assurance that specified objectives are
attained.69 Then, as now, Congress acted
to address public concerns following
several high profile cases of corporate
malfeasance. And then, as now,
arguably uncertain standards of
compliance, combined with the threat of
significant liability for non-compliance,
worked to create an atmosphere in
which companies and their advisors
strayed far from the statute’s original
65 15
U.S.C. 7262.
Rep. No. 107–205, at 31 (2002).
67 See Sections IV and V of Management’s Reports
on Internal Control Over Financial Reporting and
Certification of Disclosure in Exchange Act Periodic
Reports, SEC Release No. 33–8238 (June 5, 2003)
[68 FR 36636] (‘‘[W]e assumed that there is a direct
correlation between the extent of the burden and
the size of the reporting company, with the burden
increasing commensurate with the size of the
company.’’). The Commission did, however,
anticipate that for many companies the first-year
internal cost of compliance would be well in excess
of the average.
68 Pub. L. No. 95–213, tit. I (1977).
69 15 U.S.C. 78m(b)(2)(B).
66 S.
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11099
intent. In both instances, what began
with an idea with which few would
disagree—that companies should have
in place effective controls over their
transactions and dispositions of assets—
unexpectedly became a source of
significant anxiety, activity and
expense.
With respect to the FCPA, the fears of
public companies and their advisors
were put to rest by a speech that then
SEC Chairman Harold Williams gave in
1981, in which he outlined a
Commission approach to FCPA
compliance based upon reasonableness
and minimal intrusion in internal
corporate decision making.70 The
speech was adopted by the Commission
as an official agency interpretation and
policy statement, and retains that status
to this day.71 Chairman Williams’
approach served to calm much of the
anxiety that had arisen, and his address
and the Commission’s adoption of it as
official agency policy are not only
instructive, but also are relevant to
today’s Section 404 environment. We
urge the Commission to republish and
re-emphasize the Williams statement
and make it the framework for
management’s establishment of internal
controls.
Origin of the Current Problem
The expectation on the part of
lawmakers and regulators in enacting
and implementing Section 404 was that
if internal controls over financial
reporting are operating effectively, then
confidence in the financial statements
ipso facto will be higher. In theory, this
idea appears sound, particularly for
larger companies, where financial
statement preparation relies heavily on
the effective operation of business
process controls. The requirements that
management assess, and that the
external auditor attest to the adequacy
of, internal controls likewise appear to
be sensible objectives.
In practice, however, several factors
have led to an unexpected explosion of
activity in connection with
implementing Section 404. First,
although AS2 was developed as a guide
for external auditors in determining
whether internal control over financial
reporting is effective, no similar guide
has been developed for management.
SEC rules require management to base
its assessment of internal control over
financial reporting on a suitable,
70 See Foreign Corrupt Practices Act of 1977:
Statement of Policy, SEC Release No. 34–17500
(Jan. 29, 1981) [46 FR 11544] (presenting address by
SEC Chairman Harold Williams to AICPA Annual
Conference as Commission statement of policy)
(included as Appendix M).
71 17 CFR 241 (citing id.).
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recognized control framework. Although
the COSO Framework provides criteria
against which to assess internal control,
it does not provide management with
guidance on how to document and test
internal control or how to evaluate
deficiencies identified. Consequently
AS2 has become the de facto guide for
management, even though it was only
intended to be used as an auditing
standard; management has tried to meet
the same requirements as auditors in
performing their assessments, when in
fact management and auditors likely
perform their assessments of internal
controls differently. Adding to the
problem has been the absence of any
clear definition or guide as to what
constitutes adequate internal controls
for smaller companies. This problem
has been compounded by the different
requirements in Section 404 for
management and for their external
auditors.72 Management must assess the
effectiveness of the internal controls
over financial reporting, while the
external auditor must report on whether
management’s assessment of the
effectiveness of internal control is fairly
stated and provide (attest to) a separate
opinion on whether the company’s
internal control is effective.
Second, as both accelerated filers and
non-accelerated filers busily prepared
for the first audit of internal control and
as Section 404 implementation efforts
were taking place, there had been little
attempt to tailor, or ‘‘scale’’ regulation to
address the specific manner in which
smaller companies operate. Although
many feel that smaller companies are
operationally different from larger
companies in ways relevant to internal
controls, and hence that small
companies’ internal controls and
methods of evaluating them should be
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72 The distinction between the Section 404
requirements for management versus those for the
external auditors is misunderstood, and often
overlooked. This distinction is important because
our recommendation is that as companies grow in
size and complexity, they should take on more
expansive Section 404 requirements. For smaller
companies, we think there should be a management
assertion as to the adequacy of the internal control
over financial reporting, but that the need for the
external auditor involvement does not arise until a
company reaches a certain size and complexity.
Therefore, there is a need for a definition and guide
for management on what are adequate internal
controls for smaller companies.
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scaled accordingly, neither AS2 nor any
other source provides a clear definition
or guide for management as to what
constitutes adequate internal controls
for smaller companies.73 As noted
above, COSO is developing guidance
intended to facilitate the application of
the COSO Framework in the small
business environment; however, the
draft guidance recently exposed for
public comment by COSO does not fully
offer a solution for small businesses and
may not reduce costs of implementing
Section 404 in a small business
environment.
Moreover, even though auditors
maintain that they are already taking a
risk-based approach to the AS2 audit,
we heard significant testimony from
companies suggesting that
implementation of AS2 has resulted in
very rigid, prescriptive audits as a result
of onerous AS2 requirements. Most
issuer comments we received indicated
that auditors applied a one-size-fits-all
standard, even as auditors maintained
that each audit stands on its own; as the
Commission’s May 2005 guidance
suggests, and the input we received
confirms, auditors in many instances
utilize an approach that is ‘‘bottom-up’’
rather than ‘‘top-down.’’ 74 This results
in audits that are not risk-based and, in
particular, involve extensive testing of
information technology (IT) controls.
The result is extensive focus by auditors
on detailed processes, a number of
which create little or no risk to the
integrity of the financial statements.
Finally, the Sarbanes-Oxley Act
created the PCAOB to monitor the
performance of the external auditors.
The creation of this regulatory
watchdog, the introduction of PCAOB
73 Many believe that AS2, in practice, has proven
not to be scalable in a manner that would make it
applicable in a cost-effective way to smaller
companies. Although the PCAOB proposed for
comment a draft AS2 that included an appendix for
smaller companies, the appendix was not included
in the version of AS2 that the PCAOB and, later,
the Commission approved. Additionally, the COSO
Framework includes some guidance regarding
smaller companies but it is minimal. Many
observers acknowledge the need to scale for smaller
public companies, but because of the challenges
involved, have avoided attempting to scale despite
such need.
74 Despite the May 2005 guidance’s call for a more
top-down, risk-based approach, testimony we heard
indicated that such guidance has not substantially
altered the approach of auditors.
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inspectors and the subsequent issuance
of AS2 have altered auditor behavior
and, we believe, has diminished the
exercise of professional judgment.75
Disproportionate Impact: The Smaller
You Are, the Larger the Hit
Studies into the consequences of
Section 404 indicate that actual average
costs of Section 404 compliance have in
fact been far in excess of what was
originally anticipated. In addition,
although costs generally decline
following the first year of
implementation, a recent study
commissioned by the Big Four
accounting firms acknowledges that
second year total costs for public
companies with a market capitalization
between $75 million and $700 million
will still equal, on average,
approximately $900,000.76
But beyond the aggregate costs
involved with Section 404 compliance,
costs have been disproportionately
borne by smaller public companies. The
lack of proportionality of the cost and
amount of resources devoted to Section
404 compliance for smaller public
companies is evidenced by data which
shows that the expected cost of Section
404 implementation, as a percentage of
revenue, is dramatically higher for
smaller public companies than it is for
larger public companies. The following
chart illustrates this disparity: 77
75 See After Sarbanes-Oxley, National Law
Journal Online (Dec. 12, 2005) (remarks of former
SEC Commissioner Joseph Grundfest).
76 See CRA International Sarbanes-Oxley Section
404 Costs and Implementation Issues: Survey
Update, at 1. For further information concerning the
impact of Section 404, see American Electronics
Association, Sarbanes-Oxley Section 404: The
‘‘Section’’ of Unintended Consequences and Its
Impact on Small Business (Feb. 2005) and Financial
Executives International, FEI Special Survey on
Sarbanes-Oxley Section 404 Implementation (Mar.
2005). Although these studies are subject to further
critical analysis, they indicate considerably higher
Section 404 compliance costs than the Senate, the
SEC and others estimated.
77 This table is based on data from the Financial
Executives’ International study and estimates of the
Section 404 working group of the American
Electronics Association. We note that companies
with a market capitalization of less than $75 million
generally did not have to comply with Section 404
in 2004. Many expect that compliance costs for the
smallest companies in the chart will consequently
be much higher when such companies are required
to comply.
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11101
fees) on the cost borne by smaller public
companies, it is clear that this results in
a significant disproportionate cost for
their shareholders.
We believe that the risk of
management override in any company is
a key risk, and effective internal
controls, particularly at the entity level,
need to be in place to prevent such
overrides from occurring.80 In a smaller
public company, this risk is increased
due to top management’s wider span of
control and more direct channels of
communication. The concentration of
decision-making authority at the top of
a typical smaller company results in
78 Source: SEC Office of Economic Analysis,
Background Statistics: Market Capitalization and
Revenue of Public Companies (Aug. 2, 2005)
(included as Appendix I). We note that this graph
shows changes in fees for companies affected by
Section 404 and non-accelerated filers that have not
been required to comply with that provision’s
requirements.
79 Percentage growth varies depending on the size
of the company and measurement method. See
Tables 8, 10 & 23 in Appendix I.
80 See American Institute of Certified Public
Accountants, Management Override of Internal
Controls: The Achilles’ Heel of Fraud Prevention
(2005), available at ttp://www.aicpa.org/
audcommctr/download/achilles_heel.pdf.
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Management Override and the Resulting
Increase in Cost Structure for Smaller
Public Companies
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EN03MR06.001
between 2000 and 2004, and that the
fees for these smaller public companies
as a percentage of revenue have
remained many times higher than for
larger public companies over this
period.79
EN03MR06.000
percentage of revenue that has occurred
for companies of varying market
capitalizations, between 2000 and
2004.78 This shows that external fees for
smaller public companies have roughly
tripled as a percentage of revenue
Many commentators, including the
Commission, the Big Four audit firms,
NASDAQ and the American Electronics
Association, have estimated that the
external audit fees represent between
one quarter and one third of the total
cost of implementing Section 404. When
one factors in this multiplier (i.e., that
total Section 404 implementation costs
are three to four times external audit
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We also note that external auditor fees
have overall been increasing, both
before and after implementation of the
Sarbanes-Oxley Act. The graph below
illustrates the change in external audit
fees and audit related fees as a
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both an increased chance of fraud due
to management override, and also,
conversely and more importantly, a
significant increase in the probability
that errors or fraud in financial
reporting will be discovered through an
honest senior management process that
directly oversees financial reporting.81
This dichotomy creates much of the
tension in the debate over Section 404.
Some members of this Committee
believe that this fundamental difference
in how large and small companies are
managed deserves more focus and, as a
result, are of the view that strengthening
internal controls over top management
in the smaller company will reduce the
risk of management override and will
provide investors better protection from
a material fraud. Some also believe that,
in a smaller company, it is difficult if
not impossible for a widespread fraud to
occur that does not involve senior
management.
In smaller companies, people wear
multiple hats. It simply is not feasible
to have a person who focuses on a single
area. It also means that personnel need
to be cross trained in multiple jobs in
order to fill in as needed or when
someone is absent. The result is that
segregation of duties, a key element of
effective internal control, may not be
achievable to the extent desired. This
lack of segregation of duties requires
senior management to be involved in all
material transactions and directly
involved in financial reporting.82
Smaller companies, by their nature,
need to be flexible and the environment
they operate in requires them to make
changes quickly in order to compete
effectively with much larger and more
entrenched competitors. In fact, it is this
versatility and the ability to change
81 The COSO Framework described management
control activities for small and mid-size companies
as follows: ‘‘Further, smaller entities may find that
certain types of control activities are not always
relevant because of highly effective controls applied
by management of the small or mid-size entity. For
example, direct involvement by the CEO and other
key managers in a new marketing plan, and
retention of authority for credit sales, significant
purchases and draw downs on lines of credit, can
provide strong control over those activities,
lessening or obviating the need for more detailed
control activities. Direct hands-on knowledge of
sales to key customers and careful review of key
ratios and other performance indicators often can
serve the purpose of lower level control activities
typically found in large companies.’’ COSO
Framework at 56.
82 The COSO Framework states: ‘‘An appropriate
segregation of duties often appears to present
difficulties in smaller organizations, at least on the
surface. Even companies that have only a few
employees, however, can usually parcel out their
responsibilities to achieve the necessary checks and
balances. But if that is not possible—as may
occasionally be the case—direct oversight of the
incompatible activities by the owner-manager can
provide the necessary control.’’ Id.
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quickly that is their single most effective
competitive strength. By their nature,
smaller companies are more dynamic
and are constantly evolving, changing
and growing more rapidly than larger
companies. This dynamic nature
requires frequent changes in process
and more frequent job changes inside
the company, which limits their ability
to have static processes that are well
documented. It also creates the need for
top management involvement and
review over financial reporting. Larger
companies have more rigidly defined
roles and processes that enable them to
segregate duties to the extent that the
internal control environment can be
relied on for financial reporting. In fact,
it is essential that larger companies have
well-defined processes that enable them
to create ‘‘boundaries’’ in order to be
efficient and effective in competing with
other companies, both large and small.
This is the basic difference between
large and small companies and is at the
heart of the Committee’s
recommendations. Simply put, well
established boundaries and flexibility
are incompatible and not totally
possible in a smaller company. Section
404 and AS2 can be effective in larger
companies because of the boundaries
inherent in those companies. Many
believe that in a smaller company these
requirements cause the company to lose
its flexibility, and as a result put these
companies at a competitive
disadvantage without significantly
improving investor protection.
In our deliberations we focused on
three financial reporting concerns as
they relate to Section 404 applicability
to smaller public companies. First, the
lack of segregation of duties in these
companies creates an internal control
environment that is not primarily relied
upon for financial reporting purposes by
either management or auditors.83 It is
important to note that we believe these
companies should be concerned with
internal control, and we note that ample
law is on the books today that requires
all public companies to have an
effective internal control system in
place.84 The point is that in the smaller
public company, these controls are not
primarily relied upon for financial
reporting and are at times ineffective at
preventing fraud at the executive level.
Second, the significant risk of
management override in all companies
creates an increased need for entity
level controls and board oversight. At
the process level, controls are not
83 Id.
84 See Exchange Act § 13(b)(2)(B), 15 U.S.C.
78m(b)(2)(B) (codifying part of Foreign Corrupt
Practices Act of 1977, § 102, Pub. L. 95–213).
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effective at controlling this risk; we
believe there are more effective controls
that can be put in place to reduce the
risk of management override, especially
at smaller companies. These include an
increased oversight role for the board
and audit committee, a more robust
communication system between the
board and the executive levels of the
company, and increased scrutiny from
external auditors in key areas where
override can occur.85
Third, the requirements of AS2 and
the requirements of auditors to
document controls and the redundancy
of control testing creates an
environment in smaller companies that
limit their ability to be flexible, and
thereby hinders their competitiveness.
We believe strongly that the formation
of new companies and their ability to
access the U.S. capital markets in a
responsible manner should be
encouraged by all market participants.
Therefore we believe investor risk
protection should be encouraged. We
also strongly believe that a company
must focus on value creation for its
investors, and that our
recommendations strike a more
appropriate balance between the costs
and benefits of Section 404.
We also note that the AICPA’s
Proposed Statement on Auditing
Standards, Communication of Internal
Control Related Matters Noted in an
Audit, could be adopted by the PCAOB
to improve communication on internal
control matters between the auditor and
audit committee in the case of
companies whose internal controls are
not audited pursuant to our
recommendation.
Moreover and very importantly, the
application of not only Section 404 but
the other regulations adopted under
Sarbanes-Oxley have serious cost and
profitability ramifications for smaller
public companies in addition to the
financial reporting and management
override aspects.
First, the flexibility and requirement
to change quickly is imposed on the
smaller company by the customer; i.e.,
it is not management’s choice. It is what
the customer expects—indeed
demands—for the smaller company’s
price, which often times is slightly
higher than that charged by a larger
company. Flexibility and quick change
often means that processes and controls
change, and consequently that the
85 The COSO Framework states: ‘‘Because of the
critical importance of a board of directors or
comparable body, even small entities generally
need the benefit of such a body for effective internal
controls.’’ p. 31. See also Exposure Draft of AICPA,
Communication of Internal Control Related Matters
Noted in an Audit (Sept. 1, 2005).
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documentation of those controls change,
resulting in a cost of keeping
documentation that remains more or
less constant each year. Given this
dynamic, for smaller companies the cost
of documentation, preparation and
testing under AS2 will not likely be
reduced as much as anticipated, and not
to the extent it will in larger companies
with more stable, rigid processes.
Second, larger companies frequently
have lower material costs and can
leverage their buying power. It is not
unusual to see a whole percentage point
difference in material costs between a
large company and a small company.
The small company must offset that
large company advantage with their
package of value (service, superior
product, flexibility, adaptability).
Because the price is often set by the
customer, a smaller company must
squeeze profitability out of overhead.
That aspect of the cost structure must be
smaller when compared to the large
company. It must both offset the higher
material costs and also support
profitability, which is the ultimate
determination of shareholder value.
Increasing the burden for a small
company directly and quickly erodes
shareholder value. Because the estimate
of the costs for Section 404
implementation was underestimated so
dramatically (millions of dollars per
year, versus $91,000), the pain and loss
of value has been significantly greater
for a small company.
Third, the Sarbanes-Oxley Act not
only added Section 404 costs and other
burdens that fell disproportionately on
smaller companies, it introduced
burdens that, because of the nature of
smaller companies, will be ongoing
rather than one time. The incremental
cost of operating a board of directors, for
example, has increased because of
higher director and officer insurance
costs, the increased activity and
oversight responsibilities of the
compensation, audit and nominating
committee, more costly legal and audit
fees, and increased fees for independent
advisors to the committees, a new and
sometimes uncontrollable expense. The
pass-through cost from the supply chain
(for Sarbanes-Oxley) is starting to find
its way into the overall cost structure.
These are compounding the increased
burden cost and they are repetitive—not
one time—costs.
In summary, these characteristics,
result in frequent documentation change
and sustained review and testing for
certification under Section 404, the cost
of which is more of a sustained annual
cost. This forced cost choice, combined
with increased board operation costs
and other costs incurred as a result of
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Sarbanes-Oxley dramatically and
adversely affect the cost structure of a
small company.
Overview of Recommendations
As noted above, we believe that the
crux of the existing problem, and the
cornerstone of our recommended
solution, is that smaller and larger
public companies operate in a very
different manner. As companies grow in
size and complexity, they rely more on
formal, prescriptive and transactional
internal controls to maintain the
operations of the company. This
sentiment was confirmed by the
significant input we received indicating
that small and typically less complex
companies are very different from larger
companies and therefore, the reforms
made by the Commission and the stock
exchanges should be applied differently,
depending on the size of the company.
A number of witnesses challenged the
application of AS2 to smaller, less
complex businesses, regardless of
structure, size or strategy. Faced with
this reality, and in order to properly
scale Section 404 treatment to ensure
that the benefits of implementation
outweigh burdens, we propose differing
404 compliance requirements based
upon company size. By way of
introduction to the recommendations
below, we believe that two items bear
mentioning at the outset: (1) The opt-in
approach of our recommendations and
(2) the use of revenue filters as a means
of capturing company complexity and
consequently the cost-effectiveness of
applying Section 404 requirements.
Opt-In Approach
An essential component of the
exemptive relief we are proposing for
smaller public companies is that an
issuer, through its board of directors,
and in consultation with its audit
committee and external auditor, could
very well decide not to take advantage
of the exemptive relief available and
instead comply with the Section 404
rules applicable to larger public
companies.86
Some argue that internal control over
financial reporting should be beneficial
to smaller public companies because it
will make it easier for them to attract
capital. At this point in the
development of the internal control
requirements, we think the evidence is
quite mixed on this question and, if
anything, is tending in the opposite
86 For a discussion of the benefits of such an
optional approach, as well as the circumstances that
led to the formation of our Committee, see Roberta
Romano, The Sarbanes-Oxley Act and the Making
of Quack Corporate Governance, 114 Yale L.J. 1521,
1595–1597 (2005).
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direction. A number of data points lead
us in this direction, but we recognize
that the evidence has not been fully
analyzed and it may be premature to
make any conclusions. Nevertheless, the
following developments should be
carefully monitored:
• Some companies are either going
dark or going private or considering
doing so; 87
• The London Exchange’s Alternative
Investment Market (AIM) for smaller
public companies is gaining
momentum;88
• Foreign new listings in the United
States during 2005 dropped
considerably from the previous year; 89
• Foreign issuers are departing from
the U.S. market (and their institutional
investors are voting for their going
offshore); and
• U.S. investors continue to invest in
foreign securities even though the
87 We received several answers to this effect in
response to Question 1 of Request for Public Input
by Advisory Committee on Smaller Public
Companies, SEC Release No. 33–8599 (Aug. 5,
2005) available at https://www.sec.gov/rules/other/
265–23survey.shtml. See William J. Carney, The
Costs of Being Public After Sarbanes-Oxley: The
Irony of ‘Going Private,’ Emory Law and Economics
Research Paper No. 05–4 at 1 (February 2005)
available at SSRN: https://ssrn.com/
abstract=672761; Joseph N. DiStefano, Some Public
Firms See Benefit in Going Private, Phil. Inq., Jan.
21, 2006 (reporting on a discussion at the 11th
Annual Wharton Private Equity Conference),
available at https://www.philly.com/mld/inquirer/
business/13676241.htm. The Ziegler Companies,
Inc. is an example of a public company that decided
to delist from the American Stock Exchange and
deregister under the Exchange Act. As reasons for
the delisting and deregistration, Ziegler said, among
other things: ‘‘the costs associated with being a
reporting company under the ‘34 Act are significant
and are expected to continue to rise, thereby
diminishing the Company’s future profitability; the
benefits of remaining a listed company with
continued ’34 Act reporting obligations are not
sufficient to justify the current and expected future
costs and no analysts cover the Company’s shares.’’
Ziegler’s shares are now traded in the Pink Sheets
and the company provides its shareholders with,
among other items, annual reports including
audited financial statements, news of important
events and a proxy statement. It also has a Web
page including financial and governance
information.
88 The AIM Market is actively and successfully
prospecting for listing companies in the United
States. See G. Karmin and A. Luchetti, New York
Loses Edge in Snagging Foreign Listings, Wall St. J.,
Jan. 26, 2006, at C1, and Stephen Taub, VCs Look
For Payday in London, CFO.com, Feb. 3, 2006,
available at https://www.cfo.com/article.cfm/
5487545/c_5486496?f=TodayInFinance_Inside. See
also Letter from John P. O’Shea to Committee (June
16, 2005), available at https://www.sec.gov/rules/
other/265–23/jposhea061605.pdf. See also Record
of Proceedings 189 (Aug. 9, 2005) (testimony of
James P. Hickey, Principal, Co-Head of Technology
Group, William Blair & Co. indicating that strong
IPO candidate elected to go public on the AIM
exchange expressly to avoid costs and burdens of
Sarbanes-Oxley Act compliance).
89 See Patrick Hosking, Cull of U.S. Investors Set
a Worrying Precedent, Times Online, Feb. 2, 2006.
available at https://business.timesonline.co.uk/
article/0,,13129–2020817,00.html.
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issuers are not subject to internal
control requirements like those
promulgated under Section 404.90
Without deciding whether Section
404 is beneficial for investors in smaller
public companies, we believe that in
light of our reasons for recommending
exemptive relief for these companies,
permitting them to comply or take
advantage of the relief is the appropriate
course of action to recommend.
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Use of Revenue Filters
We would add a revenue filter or
criterion as a condition to providing
Section 404 exemptive relief for smaller
public companies, because we think
that when evaluating the costs and
benefits of applying the Section 404
requirements to smaller public
companies, revenues are a very
important factor. We believe that
companies with revenues in excess of
$250 million are generally complex, and
hence rely more on process controls to
generate their financial statements.
Because auditors of such companies, as
part of the financial audit, are likely to
have relied on and thus tested these
internal controls as part of the financial
audit in the past, it is likely to be
relatively less expensive, when
compared to smaller, less complex
companies with respect to which
controls weren’t previously tested for
purposes of the financial audit, to
comply with Section 404. Conversely,
we believe that companies with large
market capitalizations and minimal
revenues, such as development stage
companies that trade on very large
multiples because of potential, are
generally simple in terms of operations
and pose a lesser risk of material
financial fraud. Therefore, our
recommendations provide that a
smallcap company whose annual
product revenue in the last fiscal year
did not exceed $10 million would,
solely for purposes of our Section 404
recommendations, be treated the same
as a microcap company.
We acknowledge that there exists no
clear, obvious line for distinguishing
between companies based on revenues.
Our collective experience indicates,
however, that companies with revenues
of $250 million or more a year are
getting large enough and complex
enough that auditors rely more on the
90 Record of Proceedings 100 (Oct. 14, 2005)
(testimony of Gerald I. White). See also Rebecca
Buckman, Tougher Venture: IPO Obstacles Hinder
Start-ups, Wall St. J., Jan. 25, 2006, at C1 (stating
that ‘‘[l]ast year, 41 start-ups backed by venturecapital investors became publicly traded U.S.
companies, down from 67 in 2004 and 250 in the
boom year of 1999’’ and that ‘‘[o]verall IPO’s of U.S.
companies also declined last year, but not as
sharply, to 215, from 237 in 2004’’).
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internal controls to conduct the
financial statement audit than they do
for companies with less revenues.
Specifically, auditors of smaller
companies and internal financial teams
of smaller companies confirm that the
smaller the company, the less valuable
the internal control audit is to the
financial statement audit. For smaller
companies, the financial audits tend to
become more substantive in nature,
with particular attention on key, high
risk areas (inventory, revenue
recognition, etc.). Indeed, financial
experts testified that the larger the
company the more the auditor relies on
the operation of internal controls to
perform the financial statement audit.
This is because, the larger the company,
the more far flung and complex the
operations become and the less practical
it is to test significant numbers of
transactions.
Internal Control Over Financial
Reporting—Primary Recommendations
We recommend that the Commission
and other bodies, as applicable,
effectuate the following:
Recommendation III.P.1
Unless and until a framework for
assessing internal control over financial
reporting for such companies is
developed that recognizes their
characteristics and needs, provide
exemptive relief from Section 404
requirements to microcap companies
with less than $125 million in annual
revenue and to smallcap companies
with less than $10 million in annual
product revenue that have or expand
their corporate governance controls that
include:
• Adherence to standards relating to
audit committees in conformity with
Rule 10A–3 under the Exchange Act;
• Adoption of a code of ethics within
the meaning of Item 406 of Regulation
S–K applicable to all directors, officers
and employees and compliance with the
further obligations under Item 406(c)
relating to the disclosure of the code of
ethics; and
• Design and maintain effective
internal controls over financial
reporting.
In addition, as part of this
recommendation, we recommend that
the Commission confirm, and if
necessary clarify, the application to all
microcap companies, and indeed to all
smallcap companies also, of the existing
general legal requirements regarding
internal controls, including the
requirement that companies maintain a
system of effective internal control over
financial reporting, disclose
modifications to internal control over
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financial reporting and their material
consequences and apply CEO and CFO
certifications to such disclosures.91
Moreover, management should be
required to report on any known
material weaknesses. In this regard, the
Proposed Statement on Auditing
Standards of the AICPA,
‘‘Communications of Internal Control
Related Matters Noted in an Audit,’’ if
adopted by the AICPA and the PCAOB,
would strengthen this disclosure
requirement and provide some external
auditor involvement in the internal
control over financial reporting process.
Our first recommendation primarily
concerns microcap companies, which
represent the lowest 1% of total U.S.
equity market capitalization.92 In our
view, these companies should be
entitled to full Section 404 exemptive
relief, preconditioned upon their
compliance with the enhanced
corporate governance provisions
described above.93 The following
federal securities law requirements
would remain applicable to all
companies that would qualify for full
Section 404 relief in accordance with
this recommendation:
• Maintain a system of internal
controls that provides reasonable
assurances as to accuracy, as required
91 Messrs. Jensen, Schacht and Veihmeyer
dissented from the majority vote on this
recommendation. The reasons for their dissents are
contained in Parts VII, VIII and IX of this report.
All other members present voted in favor of this
recommendation.
92 The statistics we were provided indicate that
4,641, or 49%, of the 9,428 U.S. public companies
would be eligible for exemptive relief under this
recommendation. See SEC Office of Economic
Analysis, Background Statistics: Market
Capitalization and Revenue of Public Companies,
Tables 2, 19 & 26 (Aug. 2, 2005) (included as
Appendix I).
93 The approach adopted by the Committee has
been raised as a possibility by various parties. See,
e.g., Letter from Ernst & Young LLP to SEC, at 16
(Apr. 4, 2005) (Ernst & Young said, with a number
of reservations, including the lack of sufficient
information and longer term experience with 404:
‘‘Should the level of costs necessary to do the job
right be determined to be unacceptable in relation
to the benefits provided to investors in smaller
public companies, the SEC could then consider
using its exemptive authority to provide
alternatives, including annual reporting by
management on the issuer’s internal controls over
financial reporting with no auditor attestations or
with less frequent auditor attestations (for example,
auditor attestations every other year) or even
complete elimination of annual reporting by
management on the issuer’s internal controls over
financial reporting.’’) (on file in SEC Public
Reference Room File No. 4–497), available at
https://www.sec.gov/news/press/4-497/
eyllp040405.pdf. We note that Mr. Veihmeyer, in
his discussion of reasons for dissenting from this
recommendation (included in Part IX of this report),
states that after further study and experience with
Section 404 ‘‘it may become evident * * * that an
audit of internal control over financial reporting
may not be justified for certain very small public
companies that evidence certain characteristics.’’
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by Exchange Act Section 13(b)(2)(B)
enacted under the FCPA;
• Provide chief executive officer and
chief financial officer certifications
under Sarbanes-Oxley Act Section
302; 94
• Receive external financial audits;
• Comply with the requirements of
Item 9A of Form 10–K and Item 4 of Part
I of Form 10–Q; and
• Disclose, consistent with current
Section 404 rules, all material
weaknesses known to management,
including those uncovered by the
external auditor and reported to the
audit committee.95
For microcap companies that comply
with these requirements, we envision
that full Section 404 relief would be
effective immediately.
While we are convinced that the costs
associated with Section 404 compliance
are disproportionate and unduly
burdensome to smaller public
companies, we are also mindful of the
Commission’s investor protection
mandate. We believe that our
recommendation provides a more costeffective method of enhancing investor
protection. We believe that enhanced
audit committee standards and practices
and the adoption and enforcement of
ethics and compliance programs are
effective, as well as cost-effective,
means of maintaining investor
protections.
Rule 10A–3 under the Exchange Act
requires national securities exchanges
and associations to prohibit the initial
or continued listing of a security of an
issuer that is not in compliance with
specified listing standards relating to
audit committees. These standards
relate to: Audit committee member
independence; responsibility for the
appointment, compensation, retention
and oversight of an issuer’s registered
public accounting firm; the
establishment of procedures for the
receipt of accounting-related
complaints, including anonymous
94 We expect that the Section 302 certifications of
companies receiving exemptive relief from Section
404 would still be required to include the
introductory language in paragraph 4 of that
provision (which refers to the certifying officers’
responsibility for establishing and maintaining
internal control over financial reporting) and
paragraph 4(b) (which refers to the internal control
over financial reporting having been designed to
provide reasonable assurance regarding the
reliability of financial reporting and the preparation
of financial statements).
95 We considered other possible corporate
governance and disclosure standards that might be
imposed as a condition to any Section 404 relief for
smaller public companies. In the final analysis,
however, we felt that imposing conditions beyond
those described above could result in hardship for
smaller public companies that would not be
commensurate with the benefits received from an
investor protection standpoint.
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submissions by employees; the
authority to engage advisors; and
funding. The New York and American
Stock Exchanges and the NASDAQ
Stock Market have now incorporated the
requirements of Rule 10A–3 into their
respective listing standards. The audit
committee standards mandated by Rule
10A–3 currently do not apply to any
smaller public companies that are not
subject to those listing standards. We
believe that if Section 404 relief is
granted to the microcap and smallcap
companies that we recommend for
relief, those companies should, as a
condition to such relief, be required to
adhere to the audit committee standards
embodied in Rule 10A–3.
Item 406 of Regulation S–K requires a
reporting company to disclose whether
it has adopted a code of ethics that
applies to its principal executive officer,
chief financial officer and other
appropriate executives and, if it has not
adopted such a code, to state why it has
not done so. Item 406 defines a code of
ethics to be written standards that are
reasonably designed to deter
wrongdoing and to promote: Honest and
ethical conduct, including handling of
conflicts of interest; full, fair, accurate,
timely and understandable disclosure in
reports and documents filed with the
Commission and in other public
communications; compliance with
applicable governmental laws, rules and
regulations; prompt internal reporting of
violations of the code; and
accountability for adherence to the
code. A reporting company is also
required to file a copy of its code of
ethics with the Commission as an
exhibit to its annual report, or to post
the text of the code on its Web site. Item
406 mandates disclosure as to whether
a code of ethics exists, but does not
require the adoption of a code. The
major exchanges, including the NYSE,
AMEX and the NASDAQ Stock Market,
go further and require, as part of their
listing standards, the adoption of a code
of ethics meeting the fundamental
requirements embodied in Item 406, and
extend the coverage to the directors and
employees of listed companies.96 As is
the case with the audit committee
standards described above, issuers not
subject to listing standards requiring the
adoption of a code of ethics are not
obligated to do so under Commission
rules. We believe that the adoption and
enforcement of a code of ethics is both
cost effective and appropriate for
smaller public companies that receive
relief from the attestation requirements
96 New York Stock Exchange Rule 303A.10;
NASDAQ Stock Market Rule 4350(n); AMEX
Company Guide Sec. 807.
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of Section 404. A recent integrity survey
undertaken by KPMG Forensic noted
that employees who work in companies
with comprehensive ethics and
compliance programs reported fewer
observations of misconduct and higher
levels of confidence in management’s
commitment to integrity.97
With regard to the penultimate
paragraph of the recommendation
above, we simply wish for the
Commission to make clear, to the extent
clarity is lacking, that those smaller
public companies qualifying for
exemptive relief will continue to be
required to (1) maintain a system of
internal control sufficient to provide
reasonable assurance that, among other
things, transactions are recorded as
necessary to permit preparation of
financial statements in conformity with
GAAP, (2) disclose any modifications to
internal control over financial reporting
and (3) certify such disclosures.
Recommendation III.P.2
Unless and until a framework for
assessing internal control over financial
reporting for such companies is
developed that recognizes their
characteristics and needs, provide
exemptive relief from external auditor
involvement in the Section 404 process
to the following companies, subject to
their compliance with the same
corporate governance standards as
detailed in the recommendation
above: 98
• Smallcap companies with less than
$250 million in annual revenues but
greater than $10 million in annual
product revenue; and
• Microcap companies with between
$125 and $250 million in annual
revenue.99
Smallcap companies that qualify for
the Section 404 external audit of
internal control relief still would be
subject to the rest of Section 404’s
requirements, all otherwise applicable
federal securities law requirements and,
in addition, in the case of companies
not listed on the NYSE, AMEX or
NASDAQ Stock Market, all of the
corporate governance standards
97 KPMG
Forensic Integrity Survey 2005–2006.
Jensen, Schacht and Veihmeyer
dissented from the majority vote on this
recommendation. The reasons for their dissents are
contained in Parts VII, VIII and IX of this report.
All other members present voted in favor of this
recommendation.
99 The statistics we were provided indicate that
1,957, or 21%, of the 9,428 U.S. public companies
would be eligible for exemptive relief under this
recommendation. See SEC Office of Economic
Analysis, Background Statistics: Market
Capitalization and Revenue of Public Companies,
Tables 2, 19 & 26 (Aug. 2, 2005) (included as
Appendix I).
98 Messrs.
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specified above applicable to companies
so listed. Among the federal securities
law requirements that would remain
applicable to all smallcap companies
that qualify for the Section 404 external
audit of internal control exemptive
relief would be the requirements to:
• Maintain a system of internal
controls that provides reasonable
assurances as to accuracy, as required
by Exchange Act Section 13(b)(2)(B)
enacted under the FCPA;
• Complete and report on
management’s assessment of internal
control under Section 404;
• Provide chief executive officer and
chief financial officer certifications
under Section 302;
• Receive external financial audits;
• Comply with the requirements of
Item 9A of Form 10–K and Item 4 of Part
I of Form 10–Q; and
• Disclose, consistent with current
Section 404 rules, all material
weaknesses known to management,
including those uncovered by the
external auditor and reported to the
audit committee.
For smallcap companies that comply
with these requirements, we envision
that Section 404 external audit of
internal control relief would be effective
immediately.100
100 We are aware that questions have arisen
regarding the Commission’s authority to provide
exemptive relief from full compliance with the
requirements of Section 404 in accordance with this
recommendation and the recommendation above.
As a committee, we are not authorized or capable
of rendering legal opinions on this issue. We are
aware, however, that Section 3(a) of the SarbanesOxley Act, 15 U.S.C. 7202(a), provides the
Commission with broad authority to promulgate
‘‘such rules and regulations as may be necessary or
appropriate in the public interest or for the
protection of investors’’ in furtherance of Section
404. We believe that the relief we propose satisfies
this standard and that the reasoning we have
provided for our recommendations demonstrates
the reasonableness of this conclusion. Furthermore,
we are aware of the view expressed by the
Committee on Federal Regulation of Securities of
the American Bar Association’s Section of Business
Law that the Commission has authority to provide
exemptive relief for smaller public companies from
strict adherence to technical requirements of
Section 404, as follows:
‘‘We believe the Commission’s authority [to
provide relief from the auditor attestation
requirements in Section 404(b) for smaller public
companies] stems from both the [Exchange Act] and
[the Sarbanes-Oxley Act] itself. Section 36(a)(1) of
the Exchange Act gives the Commission broad
exemptive authority under the Exchange Act.
[Sarbanes-Oxley] section 3(b)(1) provides that a
violation of [the Act’s provisions] will be treated as
a violation of the Exchange Act. Therefore, under
Exchange Act Section 36(a)(1), the Commission can
adopt rules exempting classes of persons (here,
smaller public companies) from compliance with
[Sarbanes-Oxley] provisions, including * * *
Section 404(b).’’
Letter from Committee on Federal Regulation of
Securities, American Bar Ass’n, to SEC, p.4 n.2
(Nov. 28, 2005) (on file in SEC Public Reference
Room File Nos. S7–40–02 & S7–06–03), available at
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Recommendation III.P.3
While we believe that the costs of the
requirement for an external audit of the
effectiveness of internal control over
financial reporting are disproportionate
to the benefits, and have therefore
adopted the second Section 404
recommendation above, we also believe
that if the Commission reaches a public
policy conclusion that an audit
requirement is required, we recommend
that changes be made to the
requirements for implementing Section
404’s external auditor requirement to a
cost-effective standard, which we call
‘‘ASX,’’ providing for an external audit
of the design and implementation of
internal controls.101
If the Commission decides to pursue
this non-preferred alternative
recommendation, we recommend that it
direct the PCAOB to take certain steps,
and consider taking certain other steps,
in connection with developing the
necessary new Audit Standard No. X, or
ASX, described below. If those steps
have been taken and considered,
respectively, and complementary
additional guidance is available that
enables management to assess internal
controls in a cost-effective manner,102
this alternative recommendation should
be made effective for fiscal years starting
one year after the PCAOB issues
ASX.103
https://www.sec.gov/rules/proposed/s70603/
aba112805.pdf. We also are aware that the
Commission’s broad rulemaking authority under
Section 36(a)(1) of the Exchange Act may be
exercised to provide exemptive relief from the
requirements of Section 13(b)(2)(B) of the Exchange
Act, the provision that requires public companies
to devise and maintain the systems of internal
accounting controls that are the subject of
management’s internal control report and the
auditor’s report required under Section 404. We
also are aware that the Commission itself already
has provided exemptive relief from Section 404 for
certain reporting entities, such as asset-backed
issuers, indicating that the SEC believes it has
exemptive authority to provide relief from technical
compliance with Section 404. We believe the
Commission could cite these and other authorities
to demonstrate its authority to provide exemptive
relief from the requirements of Section 404. In
addition, the Commission could consider applying
the canon of construction known as ‘‘in pari
materia’’ to construe Section 404 as subject to the
Commission’s broad exemptive authority in the
Exchange Act because the two statutes relate to the
same subject matter and must be construed
harmoniously.
101 Mr. Barry abstained from the vote on this
recommendation. Messrs. Jensen, Schlein and
Veihmeyer dissented from the majority vote on this
recommendation. Mr. Jensen’s and Mr. Veihmeyer’s
reasons for their dissents are set forth in separate
statements in Parts VII and IX, respectively, of this
report.
102 The recommendation immediately below
provides details regarding the additional guidance.
103 We expect that the alternative
recommendation could be effective for fiscal years
beginning after December 31, 2007.
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The Commission should direct the
PCAOB to take the following steps:
• Develop a new audit standard for
smaller public companies (ASX) that
provides guidance for the external audit
of only the design and implementation
of internal controls to make the work
performed by auditors on internal
controls more efficient for these
companies;
• Have the standard specify a report
that would be similar in scope to the
report described in Section 501.71 of
Standards for Attestation engagements
(plus walkthroughs) of the AICPA; and
• Help to ensure that the standard
would meet the cost-effectiveness
requirement of the alternative
recommendation, by performing a costbenefit analysis before the standard is
issued in proposed form and a followup analysis before the standard is
considered for adoption.
The Commission should direct the
PCAOB to consider taking the following
steps in developing ASX:
• Involve all stakeholders in audits of
internal control and include a field trial
period to ensure that the approach is
practical and results in achievement of
required objectives;
• Take into account that a company
would more likely engage its auditors to
conduct an AS2 audit as the company
gets more complex and the auditor
plans or needs to place a high degree of
reliance on internal controls to
significantly reduce substantive audit
procedures (but an auditor still would
be permitted to place reliance on
controls to reduce substantive testing in
selected areas by testing specific
controls without performing an AS2
audit); and
• Require that:
I The same auditor perform and
integrate the ASX and financial
statement audits;
I The auditor evaluate control
deficiencies identified during the
financial statement audit to determine
their impact as to the ASX audit; and
I An auditor who identifies material
weaknesses in either the design or
operation of controls, should disclose
the material weaknesses in its report
and state that internal controls are not
effective.
Internal Control Over Financial
Reporting—Secondary
Recommendations
In addition to the foregoing primary
recommendations in the area of internal
control over financial reporting, we also
set forth below for the Commission’s
consideration the following secondary
recommendations:
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Recommendation III.S.1
Provide, and request that COSO and
the PCAOB provide, additional
guidance to help facilitate the
assessment and design of internal
controls and make processes related to
internal controls more cost-effective;
also, assess if and when it would be
advisable to reevaluate and consider
amending AS2.
Clear guidance does not yet exist for
smaller public company managers on
how to develop and support a proper
Section 404 assessment of the
effectiveness of internal control.
Section 404 requires management to
report on its assessment of the
effectiveness of the company’s internal
controls and requires an external
auditor to report on its audit of
management’s assessment and control
effectiveness. As the COSO Framework
is currently the most widely used
internal control framework in the U.S.,
managements and auditors have used it
to assess internal control. Based on the
input provided by COSO on its
framework, we have concluded that
clear guidance does not yet exist for
smaller public company managers on
how to support a proper Section 404
assessment of internal control absent
AS2.
While COSO has proposed additional
guidance for smaller companies, there is
currently little practical guidance
available to assist smaller companies in
implementing the COSO Framework in
a cost-effective manner. AS2 provides
guidance for an auditor to assess
internal control effectiveness. It was not
intended to provide management
guidance. As a practical matter,
however, because AS2 provides detailed
guidance for assessing internal control,
it is by default the standard that
management uses. We do not think that
COSO’s revised guidance for smaller
companies will result in a cost effective
or proportional alternative for
implementing Section 404.
The Commission should ask COSO to
provide additional guidance to help
management of smaller companies
assess internal controls because of the
lack of practical guidance and the
absence of a standard to enable
management of smaller companies to
address internal control.
The Commission could, for example,
ask COSO to:
• Add post-year one monitoring
guidance with selective testing where
appropriate (in this regard, we note that
the PCAOB, in its January 17, 2006
comment letter to COSO, noted that
‘‘auditability should not be the primary
goal of the guidance.’’); and
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• Emphasize that ‘‘materiality’’ for
the purposes of evaluating a ‘‘material
weakness’’ is to be determined on an
annual but not on a quarterly basis (we
note that this might require
amendments to AS2 and SEC rules).
The Commission should also ask the
PCAOB to:
• Address the ability to rely on
compensating controls (especially for
smaller public companies);
• Describe ways to reduce
compliance costs relating to information
technology controls, a significant source
of internal control compliance costs,
consistent with the underlying risks;
and
• Provide for smaller public
companies:
• If no external audit of internal
control is required, guidance on how
management, in general, can assess
internal controls efficiently and on a
stand-alone (i.e., no external auditor
involvement) basis; 104 and
• If ASX is required, guidance on
how management, in general, can assess
internal controls efficiently and in
satisfaction of the requirements of the
external auditor acting under ASX
without following the auditor-directed
guidance in ASX or AS2.
The PCAOB in its January 17, 2006
comment letter to COSO recommended
that COSO reconsider whether there is
additional, more practical guidance that
COSO could provide to smaller public
companies. We support this goal and
consider such practical guidance as
critical to smaller public companies
having a cost-effective approach to
assessing their internal controls.
We believe that the Commission also
should assess, in light of, among other
factors, existing and suggested guidance,
when it would be advisable to
reevaluate and consider amending AS2.
Furthermore, the Commission should
provide additional guidance by
clarifying considerations, and
encouraging cost-effectiveness, relating
to management’s design and assessment
of internal controls and by developing
resources to enhance the availability of
additional guidance.
In order to provide this clarification
and encouragement, the Commission
could, for example,
• State that ‘‘materiality’’ for the
purposes of assessing a ‘‘material
weakness’’ under Section 404 is to be
determined on an annual but not on a
quarterly basis;
104 While AS2 provides a way to assess internal
controls, it is designed for external auditors rather
than management and has not proven to be a costeffective tool in regard to smaller companies.
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11107
• Note the ability to rely on
compensating controls, especially for
smaller public companies; and
• Suggest methods to reduce
compliance costs relating to information
technology controls, a significant source
of internal control compliance costs,
consistent with the underlying risks.
In order to develop resources to
enhance the availability of additional
guidance, the Commission could, for
example, allocate resources to develop a
free Web site with a title such as
‘‘Center of Excellence for Reporting and
Corporate Governance for Smaller
Public Companies.’’ The Web site could
contain, for example, best practices,
frequently asked questions and complex
transaction accounting advice.
The Commission should also ask the
PCAOB to provide additional guidance
to help clarify and encourage greater
cost-effectiveness in the application of
AS2. The Commission should, for
example, ask the PCAOB to reinforce
and re-emphasize (including through
the inspection process 105) the helpful
points made in the PCAOB’s May 16
guidance 106 and its November 30, 2005
report,107 including, in particular, the
following:
• A risk-based approach is needed;
• Controls should provide
management with reasonable assurance,
not absolute or perfect certainty;
• ‘‘More than remote’’ means
‘‘reasonably possible’’ ;
• Control testing is to find material
weaknesses, and other testing should be
scaled back (i.e. testing is not to find
deficiencies and significant
deficiencies);
• The financial and internal control
audits should be integrated (especially
at smaller companies);
• All restatements should not be
treated as material weaknesses because
accounting complexity not control
deficiencies are at the root of many
restatements; and
• Management’s consultation with
the external auditor regarding the
105 See Conference Panelists Discuss Earnings
Guidance and Accounting Issues, SEC Today (Feb.
14, 2006), at 2 (quoting Teresa Iannaconi as stating
that while she believes the PCAOB is sincere in its
attempt to bring greater efficiency to the audit
process, accounting firms are not ready to ‘‘step
back,’’ because they have all received deficiency
letters, none of which say that the auditors should
be doing less rather than more).
106 PCAOB Release No. 2005–009, Policy
Statement Regarding Implementation of Auditing
Standard No. 2, an Audit of Internal Control Over
Financial Reporting Performed in Conjunction with
an Audit of Financial Statements (May 16, 2005).
107 PCAOB Release No. 2005–023, Report on the
Initial Implementation of Auditing Standard No. 2,
An Audit of Internal Control Over Financial
Reporting Performed in Conjunction with an Audit
of Financial Statements (Nov. 30, 2005).
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proper accounting for a transaction
should not lead the auditor conclude a
material weakness exists.
In addition, the Commission could
ask the PCAOB to:
• State that materiality for the
purposes of assessing a ‘‘material
weakness’’ under Section 404 should be
determined on an annual rather than
quarterly basis;
• Describe ways to reduce
compliance costs relating to information
technology controls, a significant source
of internal control compliance costs,
consistent with the underlying risks;
and
• Consider and publicize additional
ways to reduce the complexity of AS2
as currently being implemented.
Recommendation III.S.2
Determine the necessary structure for
COSO to strengthen it in light of its role
in the standard-setting process in
internal control reporting.
COSO has been placed in an elevated
role by virtue of being referenced in AS2
and the Commission’s release adopting
the Section 404 rules. While the rules
do not require the use of the COSO
Framework in performing Section 404
assessments, COSO is by far the most
widely used internal control framework
for such purposes.
In addition, COSO has issued
preliminary guidance for smaller public
companies. As a result, COSO has
become a de facto standard setting body
for preparers of financial statements
though it is not recognized as an official
standard setter, nor is it funded and
structured as one.
The Commission, in conjunction with
other interested bodies, as appropriate,
should determine the necessary
structure for COSO, including a broader
member constituency, to strengthen it in
light of its important role in establishing
and providing guidance with respect to
the internal control framework used by
most companies and auditors to
evaluate the effectiveness of internal
control over financial reporting.
*
*
*
*
*
We fully agree with the goals of recent
regulatory reforms, including the
Sarbanes-Oxley Act, and believe that
they have helped to improve corporate
governance and restore investor
confidence. These include reforms
relating to board independence,
management certifications and
whistleblower programs. We disagree
strongly, however, with the assertion
that Section 404, as currently being
implemented, is worth the significant
‘‘tax’’ it has placed on American
business, in terms of dollars spent, time
committed, and organizational
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mindshare that has been diverted from
operating and growing their businesses.
The proportionately larger costs for
smaller public companies to comply
with Section 404 may not generate
commensurate benefits, adversely
affecting their ability to compete with
larger U.S. public companies, U.S.
private companies and foreign
competitors. Smaller companies would
have to allocate their limited resources
toward Section 404 compliance even
though the required control processes
may not add significant value to their
financial statements. If their ability to
compete is diminished, these smaller
U.S. companies may find it more
difficult to raise capital to engage in
value-producing investments.
The significant, disproportionate
compliance burden placed on the
shareholders of smaller public
companies has had a negative effect on
their ability to compete with their larger
U.S. public company competitors, and,
to an even greater extent, their foreign
competitors. This reduction in the
competitiveness of U.S. smaller public
companies will hurt their capital
formation ability and, as a result, hurt
the U.S. economy. Smaller companies
have limited resources, which are being
allocated unnecessarily to internal
processes for Section 404 compliance.
Since these processes play less of a role
in the preparation of financial
statements for smaller companies, this
effort results in diminished shareholder
value that makes these companies less
attractive investments and, thereby,
harms their capital formation ability.
The major drivers of the
disproportionate burden are that smaller
companies lack the scale to costeffectively implement standards
designed for large enterprises and that
there are no guides available for
management on how to make its own
independent Section 404 assessment or
for auditors on how to ‘‘right-size AS2’’
for smaller companies.
The ‘‘cost/benefit’’ challenge is being
raised by companies of all sizes, but
most acutely by smaller companies on
which the burden of cost, time and
mindshare diversion fall most heavily.
Part IV. Capital Formation, Corporate
Governance and Disclosure
We have conducted a full review of
corporate governance and disclosure
requirements applicable to smaller
public companies. We concluded that,
in general, aside from the significant
regulatory scaling deficiencies outlined
above, the current securities regulatory
system for smaller public companies
works well to protect investors. The oral
testimony and written statements we
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received generally supported this
conclusion. We did identify some areas,
however, where we believe changes in
regulation could be made that would
reduce compliance costs without
compromising investor protection.
In terms of capital formation matters,
we heard ample testimony and reviewed
a significant amount of data regarding
the disproportionate burden that the
Sarbanes-Oxley Act, particularly
Section 404, imposes on smaller
companies. In terms of capital
formation, we believe that the increased
burden brought about by
implementation of Section 404 and
other regulatory measures have had a
significant effect on both the nature of
the relationship between private and
public capital markets and on the
attractiveness of the U.S. capital markets
in relation to their foreign counterparts.
In our view, public companies today
must be more mature 108 and
sophisticated, have a more substantial
administrative infrastructure and
expend substantially more resources
simply to comply with the increased
securities regulatory burden.
Additionally, the liquidity demands of
institutional investors, the consolidation
of the underwriting industry and the
increased cost of going public have
dictated that companies be larger,109
and effect larger transactions, in order to
undertake an initial public offering.
Stated simply, we believe that it is today
far more difficult and expensive to go—
and to remain—public than just a
decade ago, and as a consequence,
companies are increasingly turning to
the private capital markets to satisfy
their capital needs.
In light of the continued importance
of the private markets, and our
perception that most of the more
obvious regulatory impediments to the
efficient formation of capital lie in the
private realm, we are making a number
of recommendations that we believe
will improve the ability of private
companies to efficiently reach and
communicate with investors, while
continuing to protect those investors
most in need of the protections afforded
by registration under the Securities Act.
In terms of the public markets, there
is a concern that U.S. markets may
108 With respect to venture-backed startups, the
average time from initial venture financing to initial
public offering has increased from less than three
years in 1998 to more than five and a half years
today. Rebecca Buckman, Tougher Venture: IPO
Obstacles Hinder Start-ups, Wall St. J., Jan. 25,
2006, at C1.
109 The median stock market value of a venturebacked company going public last was $216
million, a marked increase from the $138 million
median value in 1997 and the just under $80
million median value in 1992. Id. at 3.
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become increasingly less attractive for
companies wishing to raise capital. The
U.S. percentage of all money raised from
foreign companies undertaking a new
stock offering declined from 90% of all
such money raised in 2000 to less than
ten percent in 2005.110
To address these issues, and to
promote healthier and more robust
capital markets, will require removing
duplicative regulation, enhancing
disclosure and promoting an improved
atmosphere for independent analyst
coverage of smaller public companies.
Capital Formation, Corporate
Governance and Disclosure—Primary
Recommendations
We recommend that the Commission
and other bodies, as applicable,
effectuate the following:
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Recommendation IV.P.1
Incorporate the scaled disclosure
accommodations currently available to
small business issuers under Regulation
S–B into Regulation S–K, make them
available to all microcap companies,
and cease prescribing separate
specialized disclosure forms for smaller
companies.
As discussed above, we are
recommending that the Commission
establish a new system of scaled or
proportional securities regulation for
smaller public companies that would
replace Regulation S–B and make scaled
regulation available to a much larger
group of smaller public companies. We
are not recommending, however, that
the scaled disclosure accommodations
now available to small business issuers
under Regulation S–B be discarded.
Instead, we are recommending that they
be integrated into Regulation S–K and
made available to all microcap
companies, defined as we recommend
under ‘‘Part II. Scaling Securities
Regulation for Smaller Companies.’’ In
Recommendation IV.P.2 immediately
below, we recommend that all scaled
financial statement accommodations
now available to small business issuers
under Regulation S–B be made available
to all smaller public companies, defined
as we recommend under ‘‘Part II.
Scaling Securities Regulation for
Smaller Companies.’’ In addition, we
110 G. Karmin and A. Luchetti, New York Loses
Edge in Snagging Foreign Listings, Wall St. J., Jan.
26, 2006, at C1 (‘‘[Undertaking an offering outside
the U.S.] would have been an unusual move as
recently as 2000, when nine out of every 10 dollars
raised by foreign companies through new stock
offerings were done in New York rather than
London or Luxembourg * * * But by 2005, the
reverse was true: Nine of every 10 dollars were
raised through new company listings in London or
Luxembourg, the biggest spread favoring London
since 1990.’’).
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are recommending that the Commission
cease prescribing separate disclosure
Forms 10–KSB, 10–QSB, 10–SB, SB–1
and SB–2 for smaller companies. All
public companies would then use the
same set of forms, such as Forms 10–K,
10–Q, 10, S–1 and S–3.
As discussed briefly above,
Regulation S–B was adopted by the
Commission in 1992 as an integrated
registration and reporting system
covering both disclosure and financial
statement rules for ‘‘small business
issuers.’’ 111 ‘‘Small business issuer’’ is
defined as an issuer that with both
revenues and a public float of less than
$25 million.112 The system provides
specialized forms under the Securities
and Exchange Acts with disclosure and
financial statement requirements that
are somewhat less rigorous than the
requirements applicable to larger
companies under Regulation S–K, the
integrated disclosure system, and
Regulation S–X, the integrated financial
statement system, for larger
companies.113
We reviewed the benefits and
drawbacks of Regulation S–B and
considered whether the
accommodations in Regulation S–B
should be expanded, contracted, or
extended to a broader range of smaller
public companies. We considered oral
and written testimony as to the benefits
and limitations of Regulation S–B,
including testimony and discussion
during a joint meeting with the
Commission’s annual Forum on Small
Business Capital Formation.114
111 Small Business Initiatives, SEC Release No.
33–6949 (July 30, 1992) [57 FR 36442]. Regulation
S–B is codified at 17 CFR 228.10 et seq.
112 In addition, small business issuers must be
U.S. or Canadian companies, cannot be investment
companies or asset-backed issuers and cannot be
majority owned subsidiaries of companies that are
not small business issuers. 17 CFR 228.10(a)(1).
113 Regulation S–K is codified at 17 CFR 229.10
et seq. Regulation S–X, which provides accounting
rules for larger companies, is codified at 17 CFR
210.01.01 et seq. The accounting rules for small
business issuers using Regulation S–B generally are
contained in Item 310 of Regulation S–B, 17 CFR
228.310.
114 See Record of Proceedings 48, 143, 148 (June
17, 2005) (testimony of William A. Loving, David
N. Feldman and John P. O’Shea. See also Letter
from Brad Smith to Committee (May 24, 2005) (on
file in SEC Public Reference Room), available at
https://www.sec.gov/rules/other/265–23/
bsmith2573.htm; Letter from Kathryn Burns to
Committee (May 24, 2005), available at https://
www.sec.gov/rules/other/265–23/kburns052405.pdf;
Letter from David N. Feldman to Committee (May
30, 2005, available at https://www.sec.gov/rules/
other/265–23/dnfeldman053005.htm; Letter from
Michael T. Williams to Committee (May 30, 2005),
available at https://www.sec.gov/rules/other/265–23/
mtwilliams6614.pdf; Letter from KPMG to
Committee (May 31, 2005), available at https://
www.sec.gov/rules/other/265–23/kpmg053105.pdf;
Letter from BDO Seidman to Committee (May 31,
2005), available at https://www.sec.gov/rules/other/
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11109
Listed below are the primary
disclosure accommodations currently
available to small business issuers
under Regulation S–B. We are
recommending that all of these be
integrated into Regulation S–K and be
made available to all microcap
companies. Microcap companies would
have the option of following the
disclosure requirements for larger
companies if they chose to do so.
• Under Item 101 of Regulation S–B,
small business issuers are required to
provide a less detailed description of
their business and to disclose business
development activities for only three
years, instead of the five years required
of larger companies by Regulation S–K.
• Regulation S–B currently does not
include an Item 301 (selected financial
data) or Item 302 (supplementary
financial information), which are
included in Regulation S–K, meaning
that small business issuers are not
required to disclose this information.
• Regulation S–B provides for more
streamlined disclosure for
management’s discussion and analysis
of financial condition and results of
operations by requiring only two years
of analysis if the company is presenting
only two years of financial statements,
instead of the three years required of
companies that present three years of
financial statements, as required under
Regulation S–K.115
• Regulation S–B does not require
smaller companies to provide a tabular
disclosure of contractual obligations as
larger companies must do under Item
303(a)(5) of Regulation S–K.116
• Regulation S–B does not require
small business issuer filings to contain
quantitative and qualitative disclosure
about market risk section as required of
larger companies under Item 305 of
Regulation S–K.117
265–23/bdoseidman053105.pdf; Letter from
Stephen M. Brock (May 31, 2005), available at
https://www.sec.gov/rules/other/265–23/
smbrock1317.pdf; Letter from Ernst & Young (May
31, 2005), available at https://www.sec.gov/rules/
other/265–23/ey053105.pdf; Letter from Small
Business & Entrepreneurship Council to Committee
(May 31, 2005), available at https://www.sec.gov/
rules/other/265–23/kkerrigan8306.pdf; Letter from
Society of Corporate Secretaries & Governance
Professionals (June 7, 2005), available at https://
www.sec.gov/rules/other/265–23/sspc-slcscsgp060705.pdf; Letter from Mark B. Barnes to
Committee (August 2, 2005), available at https://
www.sec.gov/rules/other/265–23/
mbbarnes080205.pdf; and Letter from Gregory C.
Yardley, Jean Harris, Stanley Keller, A. John
Murphy, and A. Yvonne Walker to Committee
(Sept. 12, 2005), available at https://www.sec.gov/
rules/other/265–23/gcyadley091205.pdf.
115 MD&A requirements are found in Item 303 of
both Regulation S–K and Regulation S–B, 17 CFR
229.303 & 17 CFR 228.303.
116 17 CFR 229.303(a)(5).
117 17 CFR 229.305.
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• Under Item 402 of Regulation S–B,
small business issuers currently are not
required to include a compensation
committee report or a stock performance
graph in their executive compensation
disclosures, as larger companies are
required to do under Item 402 of
Regulation S–K.118
We have numerous reasons for
recommending the abandonment of
Regulation S–B as a separate, stand
alone integrated disclosure system,
including the abandonment of separate
prescribed forms for small business
issuers. The drawbacks associated with
Regulation S–B include a lack of
acceptance of ‘‘S–B filers’’ in the
marketplace, a possible stigma
associated with being an S–B filer, and
the complexity for the SEC and public
companies and their counsel of
maintaining and staying abreast of two
sets of disclosure rules that are
substantially similar. Further, we
received input that many securities
lawyers saying they are not familiar
with Regulation S–B and therefore are
hesitant to recommend that their clients
use this alternative disclosure
system.119
We heard numerous comments to the
effect that the thresholds for using
Regulation S–B are too low and should
be increased to permit a broader range
of smaller public companies to be
eligible for its benefits, particularly in
light of the increased costs associated
with reporting obligations under the
Exchange Act since passage of the
Sarbanes-Oxley Act.120
118 Executive compensation disclosure
requirements are found in Item 402 of both
Regulation S–K and Regulation S–B, 17 CFR
228.402 and 17 CFR 229.402. The Commission
recently proposed major amendments to the
executive compensation disclosure rules under both
Regulation S–B and Regulation S–K. See Executive
Compensation and Related Party Disclosure, SEC
Release No. 33–8655 (Jan. 27, 2006) [71 FR 6541].
We recommend that the Commission apply
whatever executive compensation disclosure rules
ultimately are adopted for smaller issuers to
microcap companies as we propose to define that
term rather than only to small business issuers as
currently defined under Regulation S–B.
119 See Record of Proceedings 48, 143, 148 (June
17, 2005) (testimony of William A. Loving, David
N. Feldman and John P. O’Shea).
120 See Letter from Brad Smith to Committee (May
24, 2005) available at https://www.sec.gov/rules/
other/265–23/bsmith2573.htm); Letter from Kathryn
Burns to Committee (May 24, 2005), available at
https://www.sec.gov/rules/other/265–23/
kburns052405.pdf; Letter from David N. Feldman to
Committee (May 30, 2005) available at https://
www.sec.gov/rules/other/265–23/
dnfeldman053005.htm; Letter from Michael T.
Williams to Committee (May 30, 2005), available at
https://www.sec.gov/rules/other/265–23/
mtwilliams6614.pdf; Letter from KPMG to
Committee (May 31, 2005), available at https://
www.sec.gov/rules/other/265–23/kpmg053105.pdf;
Letter from BDO Seidman to Committee (May 31,
2005), available at https://www.sec.gov/rules/other/
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In summary, we believe that
incorporating the disclosure
accommodations currently available to
small business issuers under Regulation
S–B into Regulation S–K, rather than
retaining them in a separate but similar
and parallel system, will result in many
benefits. Among them, any stigma
associated with taking advantage of the
accommodations would be lessened. In
addition, this would reduce the
complexity of SEC rules, in keeping
with the overarching goal expressed in
our Committee Agenda of ‘‘keeping
things simple.’’
Recommendation IV.P.2
Incorporate the primary scaled
financial statement accommodations
currently available to small business
issuers under Regulation S–B into
Regulation S–K or Regulation S–X and
make them available to all microcap and
smallcap companies.
As discussed above, we are
recommending that the Commission
establish a new system of scaled or
proportional securities regulation for
smaller public companies that would
replace Regulation S–B. In
Recommendation IV.P.1 immediately
above, we recommend that the
disclosure accommodations currently
available to small business issuers
under Regulation S–B be made available
to all microcap companies, as we have
recommended that term be defined in
‘‘Part II. Scaling Securities Regulation
for Smaller Companies’’ above. In this
recommendation, we recommend that
the primary financial statement
accommodations currently afforded to
small business issuers under Regulation
S–B be made available to all ‘‘smaller
public companies’’ as we have
recommended that term be defined
above. Adopting this recommendation
would mean that both microcap
companies and smallcap companies, as
we would have the Commission define
those terms, would be entitled to take
265–23/bdoseidman053105.pdf; Letter from
Stephen M. Brock to Committee (May 31, 2005),
available at https://www.sec.gov/rules/other/265–23/
smbrock1317.pdf; Letter from Ernst & Young to
Committee (May 31, 2005), available at https://
www.sec.gov/rules/other/265–23/ey053105.pdf;
Letter from Small Business & Entrepreneurship
Council to Committee (May 31, 2005), available at
https://www.sec.gov/rules/other/265–23/
kkerrigan8306.pdf; Letter from Society of Corporate
Secretaries & Governance Professionals to
Committee (June 7, 2005), available at https://
www.sec.gov/rules/other/265–23/sspc-slcscsgp060705.pdf; Letter from Mark B. Barnes to
Committee (Aug. 2, 2005). available at https://
www.sec.gov/rules/other/265–23/
mbbarnes080205.pdf; and Letter from Gregory C.
Yardley, Jean Harris, Stanley Keller, A. John
Murphy, and A. Yvonne Walker to Committee
(Sept. 12, 2005), available at https://www.sec.gov/
rules/other/265–23/gcyadley091205.pdf.
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advantage of financial statement
accommodations now available only to
small business issuers.
The primary financial statement
accommodation now afforded to small
business issuers is provided under Item
310 of Regulation S–B. That provision
permits small business issuers to file
two years of audited income statements,
cash flows, and changes in stockholders
equity and one year of audited balance
sheet data in annual reports and
registration statements. Larger public
companies are required to file three
years of audited income statement and
other data and two years of audited
balance sheet data under Regulation
S–X.121 We recommend that smaller
public companies be required to file
only two years of audited income
statements, cash flows, and changes in
stockholders equity but two years of
audited balance sheet data in annual
reports and registration statements.
We believe that requiring a second
year of audited balance sheet data for
smaller public companies provides
investors with a basis for comparison
with the current period, without
substantially increasing audit costs. On
the other hand, we believe that
eliminating the third year of audited
income statement, cash flow and
changes in stockholders equity data for
smaller public companies will reduce
costs and simplify disclosure while not
adversely impacting investor protection
in any significant way. Third year data
and corresponding analysis is generally
less relevant to investors than the more
current data and third year data is often
readily obtainable online.122 If the
company has been a reporting company
for three years, the third year data
should be readily accessible through the
Commission’s EDGAR system and other
sources. Investors today have access to
numerous years of financial information
about any reporting company because of
the significant technological advances
in obtaining financial information about
reporting issuers. We do not believe that
investors will be harmed in any
significant way if the Commission
adopts this recommendation.
121 17 CFR 210.1–01 et seq. The financial
statement rules applicable to small business issuers
appear in Item 310 as part of Regulation S–B,
whereas the financial statement rules applicable to
larger companies appear in Regulation S–X, an
entirely separate regulation. We take no position on
whether the financial statement rules that would
apply to all smaller public companies under our
recommendation should appear in Regulation S–K
as a separate set of rules applicable to all smaller
public companies, or in Regulation S–X.
122 See Internet Availability of Proxy Materials,
SEC Release No. 34–52926 (Dec. 15, 2005) [70 FR
74598].
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Moreover, we believe that eliminating
the third year of income statement, cash
flow and stockholders equity data for
smaller public companies will reduce
costs and simplify disclosure.
Eliminating the third year of audited
income statement and other data may
serve to reduce costs associated with
changing audit firms by eliminating
certain of the expenses and processes
associated with predecessor auditor
consent requirements. An issuer’s prior
auditors must execute consents in order
for financial statements previously
audited by that firm to be included in
SEC reports and registration statements.
Adopting this recommendation may
make it easier for smaller public
companies to change their auditors,
thereby increasing competition among
auditing firms.
In addition, we believe that the
following financial statement
accommodations currently provided to
small business issuers would be
afforded to all smaller public companies
if this recommendation is adopted:
• In an initial public offering, small
business issuers have a longer period of
time in which they do not have to
provide updated audited financial
statements in their registration
statements. For example, for non-small
business issuers, if the effective date of
the registration statement for the initial
public offering falls after 45 days of the
end of the issuer’s fiscal year, the nonsmall business issuer must provide
audited financial statements in their
registration statement for the most
recently completed year, with no
exceptions. For small business issuers,
if the effective date of the registration
statement falls after 45 days but within
90 days of the end of the small business
issuer’s fiscal year, the small business
issuer is not required to provide the
audited financial statements for such
year end, provided that the small
business issuer has reported income for
at least one of the two previous years
and expects to report income for the
recently-completed year.123
• Issuers filing a registration
statement under the Exchange Act
(which is currently filed on Form 10–SB
but would be filed on Form 10 if our
previous recommendation is adopted)
need not audit the financial statements
for the previous year if those financial
statements have not been audited
previously. This also applies to any
financial statements of recently acquired
businesses or pending acquisitions that
are included in an Exchange Act
registration statement.
123 See
17 CFR 228.310(g)(2).
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• Small business issuers need not
provide financial statements of
significant equity investees, as required
by Rule 3–09 of Regulation S–X, in any
document filed with the SEC.
Small business issuers domiciled in
Canada may present their financial
statements in accordance with Canadian
GAAP and reconcile those financial
statements to U.S. GAAP. Any nonsmall business issuer filing a
registration statement on a domestic
form, such as Form S–1, S–3 or S–4,
must present its financial statements in
accordance with U.S. GAAP and
provide all disclosures required under
U.S. GAAP.
Recommendation IV.P.3
Allow all reporting companies on a
national securities exchange, NASDAQ
or the OTCBB to be eligible to use Form
S–3, if they have been reporting under
the Exchange Act for at least one year
and are current in their reporting at the
time of filing.
Form S–3 is a short-form registration
statement under the Securities Act that
allows companies eligible to use it
maximum use of incorporation by
reference to information previously filed
with the Commission.124 As discussed
below, we recommend that the
efficiencies associated with the use of
Form S–3 be made available to all
companies that have been reporting
under the Exchange Act for at least one
year, and are current in their Exchange
Act reporting at the time of filing.
Additionally, we recommend
elimination of the current condition to
the use of Form S–3 that the issuer has
timely filed all required reports in the
last year.
Current SEC rules allow issuers with
over $75 million in public float to use
Form S–3 in primary offerings.
Additionally, Form S–3 may be used for
secondary offerings for the account of
any person other than the issuer if
securities of the same class are listed
and registered on a national securities
exchange or are quoted on NASDAQ.
Many smaller public companies are not
eligible to use Form S–3 in primary
offerings because their public float is
below $75 million; they also cannot use
Form S–3 in secondary offerings
because their securities are not listed on
a national securities exchange or quoted
on NASDAQ.
Since 1999, the NASD has required
companies traded on its Over-the124 Form S–3 can be found at 2 Fed. Sec. L. Rep.
(CCH) ¶ 7151. Form S–3 was originally adopted in
Revisions of Certain Exemptions from Registration
for Transactions Involving Limited Offers and Sales,
SEC Release No. 33–6383 (Mar. 3, 1982) [47 FR
11380].
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11111
Counter Bulletin Board (‘‘OTCBB’’) 125
to file reports under the Exchange Act.
Under Exchange Act rules, registrants
must file annual and quarterly reports
disclosing information about their
companies. Registrants also have an
obligation to file current reports when
certain events occur. All reporting
companies have the same disclosure
obligations as the largest of public
companies. And, in order to take
advantage of the Section 404 exemptive
relief we are recommending for
microcap companies, all those reporting
companies included in the Pink Sheets
would need to be current in their SEC
periodic reporting obligations. Their
disclosure should be sufficient to
protect investors and inform the
marketplace about developments in
these companies. As online accessibility
to previously filed documents on
corporate and other Web sites, including
the SEC’s EDGAR Web site, increases;
smaller public companies should be
permitted to take advantage of the
efficiency and cost savings of
incorporation by reference to
information already on file. The
Commission has recently taken several
steps acknowledging the widespread
accessibility over the Internet of
documents filed with the SEC. In its
recent release concerning Internet
delivery of proxy materials,126 the
Commission noted that recent data
indicates that up to 75% of Americans
have access to the Internet in their
homes, and that this percentage is
increasing steadily among all age
groups. As a result, we believe that
investor protection would not be
materially diminished if all reporting
companies on a national securities
exchange, NASDAQ or the OTCBB were
permitted to utilize Form S–3 and the
associated benefits of incorporation by
reference. Further, the smaller public
companies that would be newly entitled
to use Form S–3 if this recommendation
is adopted would not enjoy the
automatic effectiveness of registration
statements, as is the case with well
known seasoned issuers under the SEC’s
recent Securities Act Reform rules.127
Accordingly, the SEC staff can elect to
review the registration statement and
documents of smaller public companies
125 The OTCBB is a regulated quotation service
that displays real-time quotes, last-sale prices, and
volume information in over-the-counter (OTC)
equity securities. An OTC equity security generally
is any equity security that is not listed or traded on
NASDAQ or a national securities exchange.
126 See Internet Availability of Proxy Materials,
SEC Release No. 34–52926 (Dec. 15, 2005) [70 FR
74598].
127 See Securities Offering Reform, SEC Release
No. 33–8591 (July 19, 2005) [70 FR 44722].
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incorporated by reference if it chooses
to do so. Additionally, the SarbanesOxley Act has required more frequent
SEC review of periodic reports as well
as enhanced processes, such as
disclosure controls and procedures and
certifications by the chief executive and
chief financial officers, which further
enhances investor protection. We
believe the adoption of this
recommendation will also facilitate
capital formation by reducing costs of
smaller public companies and providing
more rapid access to the capital markets.
We further recommend that
corresponding changes be made to other
forms providing similar streamlined
disclosure for S–3 eligible issuers, such
as Form S–4.
We acknowledge that some members
of the public may believe that
recommending Form S–3 eligibility for
all reporting companies is contrary to
our recommendation seeking relief from
Sarbanes-Oxley Act Section 404 but we
believe strongly that all reporting
companies should have the same
efficient access to the market as large
reporting companies. Microcap
companies have the same reporting
obligations as the largest of reporting
companies and should not be penalized
because of size. The changes in
reporting requirements of microcap
companies on the OTCBB support this
recommendation.
We recommend that the Commission
eliminate the requirement that the
registrant has filed in a timely manner
all reports required to be filed during
the preceding 12 calendar months as a
condition to the use of Form S–3, if the
issuer has been reporting under the
Exchange Act for at least 12 months
and, at the time of such filing, has filed
all required reports. We believe that the
risk of SEC enforcement action,
delisting notifications and
accompanying disclosure, and
associated negative market reactions are
sufficient and more appropriate
deterrents to late filings, and depriving
late filers of an efficient means to access
the capital markets is unduly
burdensome to issuers, both large and
small.128
General Instructions to Form S–3
limit the use of that form for secondary
offerings to securities ‘‘listed and
registered on a national securities
exchange or * * * quoted on the
automated quotation system of a
national securities association,’’ a
restriction that by definition excludes
128 To prevent issuers from taking advantage of
the system by, for instance, becoming current on
day one and filing a Form S–3 on day two, the
Commission could require that the issuer be current
for at least 30 days before filing a Form S–3.
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the securities of OTCBB issuers. As a
consequence, OTCBB issuers that
undertake private placements with
associated registration rights, or that are
required to register affiliate or Rule 145
shares, are required to file a registration
statement on Form S–1 or Form SB–2
and incur the substantial burden and
expense that the continuous updating of
those forms require.
When the Commission adopted Form
S–3 in 1982, the distinction drawn
between OTCBB and exchange and
NASDAQ-traded securities was logical.
OTCBB issuers were not at the time
required to file Exchange Act reports
with the SEC. In 1999, however, the
NASD promulgated new eligibility rules
that required all issuers of securities
quoted on the OTCBB to become SEC
reporting companies and be current in
its Exchange Act filings, making the
need for such a distinction less
apparent.129
We concur with the Commission’s
original analysis in 1982 that ‘‘most
secondary offerings are more in the
nature of ordinary market transactions
than primary offerings by the registrant,
and, thus, that Exchange Act reports
may be relied upon to provide the
marketplace information needed
respecting the registrant.’’ 130 In light of
the current requirement that OTCBB
issuers also be SEC reporting
companies, we believe that extending
Form S–3 eligibility for secondary
transactions to OTCBB issuers is
consistent with the rationale underlying
Form S–3 at the time of its adoption.
Moreover, allowing such use of Form S–
3 would benefit OTCBB issuers by (1)
eliminating unnecessary, duplicative
disclosure while ensuring that security
holders, investors and the marketplace
are provided with the necessary
information upon which to base an
investment decision and (2)
substantially reducing the costs
associated with undertaking a private
financing.
Recommendation IV.P.4
Adopt policies that encourage and
promote the dissemination of research
on smaller public companies.
The trading markets for public
companies are assisted in great measure
by the dissemination of quality
investment research. Investment
research coverage for public companies
in general, and for smaller public
129 Press Release, NASD, NASD Announces SEC
Approval of OTC Bulletin Board Eligibility Rule
(Jan. 6, 1999).
130 See Revisions of Certain Exemptions from
Registration for Transactions Involving Limited
Offers and Sales, SEC Release No. 33–6383, at 10
(Mar. 3, 1982) [47 FR 11380].
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companies in particular, has declined
dramatically in recent years, however,
as economic and regulatory pressures
have led the financial industry to
dramatically reduce research budgets.131
The problem is particularly pronounced
in the case of smallcap companies, of
which less than half receive coverage by
even a single analyst, and in the
microcap universe, where analyst
coverage is virtually non-existent.132
The existing regulatory framework
and business environment exacerbates
this problem, and commission rates
have declined for firms that historically
used these revenue streams to fund
research. Business models have emerged
to create published research in order to
fill the resulting void, although their
involvement with independent research
providers that also participate in the
global settlement agreement has until
recently been uncertain.133
131 A recent article notes, for instance, that fewer
companies are receiving analyst coverage today
than at any time since 1995. Where’s the Coverage?,
CFO Magazine (Jan. 20, 2005), available at https://
www.cfo.com/article.cfm/3516678/
c_3576955?f=home_todayinfinance.
132 Testimony provided to the Committee
indicated that approximately 1,200 of the 3,200
NASDAQ-listed companies, and 35% of all public
companies, receive no analyst coverage at all. See
Record of Proceedings 17 (June 17, 2005) (testimony
of Ed Knight, Vice President and General Counsel
of NASDAQ). Statistics provided by the SEC Office
of Economic Analysis indicate that in 2004
approximately 52% of companies with a market
capitalization between $125 million and $750
million and 83% of companies with a market
capitalization less than $125 million had no analyst
coverage.
133 In the course of the Advisory Committee’s
proceedings, we were made aware of one informal
clarification regarding administration of the global
settlement agreement in the recent analyst coverage
enforcement cases that will likely have a beneficial
effect on the availability of independent research.
As members of the Commission are aware, one
aspect of the global settlement agreement provides
that, for a period of five years commencing in 2004,
investment banks that are parties to the settlement
are required to provide to their U.S. customers
independent research reports alongside their own
research reports on certain companies that their
analysts cover. Entities that provide independent
research reports to the settling banks (‘‘independent
research providers’’ or ‘‘IRPs’’) cannot also conduct
‘‘paid-for’’ research, i.e., research done on behalf of,
and paid for by, individual companies. Because
many IRPs do not want to be excluded from
participating in the global settlement, the effect of
this prohibition—at least in the view of some—was
to limit the number of entities willing to undertake
paid-for research on behalf of individual
companies.
In October 2005, the five regulators overseeing
implementation of the global settlement informed
the independent consultants (essentially the
persons responsible for procuring the independent
research under the settlement) of how the
settlement applies to independent research
intermediaries that match companies and IRPs on
a ‘‘blind pool’’ basis (i.e., a complete wall is
maintained between the entity that purchases the
research, most likely the company being analyzed,
and the selection of an IRP to conduct the research).
Although no formal pronouncement was issued,
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A lack of independent analyst
coverage has several adverse effects,
both for individual companies and for
the capital markets as a whole:
• Companies with no independent
analyst coverage have a reduced market
capitalization in comparison with
companies that do have such coverage,
and are subject to higher financing costs
when compared with their analystcovered peers; 134
• A lack of coverage by independent
analysts limits shareholders’ and
prospective shareholders’ ability to
obtain an informed outsider’s
perspective on identifying strengths and
weaknesses and areas for improvement;
• The lack of coverage lessens the
entire ‘‘mix of information’’ made
available to investment bankers, fund
managers and individual investors,
which make markets less efficient; and
• Because analyst reports trigger the
buying and selling of shares, the lack of
such reports frustrates the formation of
a robust trading market.135
In order to address the need for more
independent research for smaller public
companies, we recommend that the
Commission:
• Maintain policies that allow
company-sponsored research to occur
with full disclosure by the research
provider as to the nature of the
relationship with the company being
covered. Entities providing such
research should disclose and adhere to
a set of ethical standards that ensure
quality and transparency and minimize
conflicts of interest.136
• Continue to permit ‘‘soft dollar’’
payments (i.e., the use of client
regulators responsible for the enforcement of the
global settlement told the independent consultants
that they have the discretion to decide whether or
not to procure independent research from IRPs that
also contract with independent research
intermediaries, provided that certain conditions are
met.
134 A recent study on the effects of Regulation FD
finds that when smaller companies lost analyst
coverage after the regulation was enacted their cost
of capital increased significantly. See Armando
Gomes et al., SEC Regulation Fair Disclosure,
Information, and the Cost of Capital (Rodney L.
White Center for Fin. Research, Wharton School U.
Pa., Working Paper No. 10567) (July 8, 2004).
135 Rebecca Buckman, Tougher Venture: IPO
Obstacles Hinder Start-ups, Wall St. J., Jan. 25,
2006, at C1.
136 Section 17(b) of the Securities Act provides:
‘‘It shall be unlawful for any person, by the use of
any means or instruments of transportation or
communication in interstate commerce or by the
use of the mails, to publish, give publicity to, or
circulate any notice, circular, advertisement,
newspaper, article, letter, investment service, or
communication which, though not purporting to
offer a security for sale, describes such security for
a consideration received or to be received, directly
or indirectly, from an issuer, underwriter, or dealer,
without fully disclosing the receipt, whether past or
prospective, of such consideration and the amount
thereof.’’
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commissions to pay for research
services) under the safe harbor
provisions of current Exchange Act
Section 28(e), as amplified by guidance
set forth in SEC Release No. 34–52635.
We acknowledge that these two
recommendations do not request
significant changes in existing SEC
policies, but rather, call for more or less
continuation of existing policies.
Despite a shared conviction that
independent analyst coverage is critical
to the success of smaller public
companies and to the efficient operation
of our capital markets, we were unable
to identify specify regulatory
impediments that could be modified in
a manner that would be consistent with
the Commission’s investor protection
mandate. We nonetheless have included
these two recommendations in order to
highlight for the Commission the
existing problem, to ask that existing
policies be maintained and to request
that the Commission continue to search
for new ways to promote analyst
coverage for smaller public companies.
Recommendation IV.P.5
Adopt a new private offering
exemption from the registration
requirements of the Securities Act that
does not prohibit general solicitation
and advertising for transactions with
purchasers who do not need all the
protections of the Securities Act’s
registration requirements. Additionally,
relax prohibitions against general
solicitation and advertising found in
Rule 502(c) under the Securities Act to
parallel the ‘‘test the waters’’ model of
Rule 254 under that Act.
The ban on general solicitation and
advertising in connection with exempt
private offerings dates back to some of
the earliest SEC staff interpretations of
the Securities Act.137 Although the
initial intention of the ban is
straightforward, over time its
application has become complex. Few
bright-line tests exist, and issuers are
required to make highly subjective
determinations concerning whether
their actions might be construed as
impermissible. Among the factors the
SEC staff has considered in determining
if a general solicitation has occurred are:
the number of offerees; their suitability
as potential investors; how the offerees
were contacted; and whether the
offerees have a pre-existing business
relationship with the issuer.
Beyond the difficulty of determining
if particular contact is impermissible,
however, the current ban on general
solicitation and advertising effectively
137 See, e.g., SEC Release No. 33–285 (Jan. 24,
1935).
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prohibits issuers from taking advantage
of the tremendous efficiencies and reach
of the Internet to communicate with
potential investors who do not need all
the protections of the Securities Act’s
registration requirements. In our view,
this is a significant impediment to the
efficient formation of capital for smaller
companies, one that could easily be
corrected by modernizing the existing
prohibitions on advertising and general
solicitation.
Traditionally, both federal and state
private offering exemptions have been
conditioned on the absence of
‘‘advertising or general solicitation.’’
These concepts and SEC interpretations
have not provided bright-line objective
criteria for issuers and their advisers.
Nevertheless, when it comes to exempt
transactions, issuers face draconian
risks to the viability of the entire
offering for non-compliance with just
one of the many required exemption
elements. For example, even if all
purchasers (A) are accredited investors,
(B) have pre-existing business
relationships with the issuing company
and (C) are contacted in face-to-face
meetings, some case law supports the
view that the exemption will
nevertheless be lost for the entire
offering if other issuer activities are
found to have involved general
solicitation or advertising. This could
occur, for example, if the issuer made
offers at a social function to 50
prospective purchasers, all of whom
were social friends of the issuing
company’s principals but with whom
the company did not enjoy pre-existing
business relationships. A similar
adverse result could occur if the issuer
or an agent of the issuer placed an
advertisement on a local cable TV show,
Internet web page or newspaper that
featured the issuer’s capital formation
interests. In these examples, the
exemption could be lost (and all
purchasers could seek a return of their
invested funds) even though none of the
offerees contacted in an impermissible
manner became purchasers. As a result,
prudence dictates that the available
methods used to contact offerees be very
limited. In our view, concerns with
avoiding improper general solicitation
or advertising have the effect of focusing
a disproportionate amount of time and
effort on persons who may never
purchase securities—rather than on the
actual investors and their need for
protection under the Securities Act.
Accordingly, we recommend the
adoption of a new private offering
exemption that would permit sales
made only to certain eligible purchasers
who do not require the full protections
afforded by the securities registration
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process under the Securities Act
because of (1) financial wherewithal, (2)
investment sophistication, (3)
relationship to the issuer or (4)
institutional status. An offering whose
purchasers consisted solely of eligible
purchasers of these types would qualify
for the exemption regardless of the
means by which they were contacted—
even through advertising or general
solicitation activities, subject to the
restrictions noted below.
• The class of eligible purchasers
would be comprised of several
categories of natural persons and legal
entities and would be defined in a
manner similar to that used in
Regulation D under the Securities
Act 138 to define the term ‘‘accredited
investors.’’ 139
• Natural persons would qualify as
eligible purchasers based on (1) wealth
or annual income, (2) investment
sophistication,140 (3) position with or
relationship to the issuer (officer,
director, key employee, existing
significant stockholder, etc.) or (4) preexisting business relationship with the
issuer. Persons closely related to or
associated with eligible purchasers
would also qualify as eligible
purchasers.
• The financial wherewithal
standards for natural persons to qualify
as eligible purchasers would be
substantially higher than those currently
in effect for natural person Accredited
Investors.141 We suggest $2 million in
joint net worth or $300,000 in annual
income for natural persons and
$400,000 for joint annual income.142
• Legal entities would qualify as
eligible purchasers if they qualify as
accredited investors under Regulation
D.
• The SEC should adopt the new
exemption amending Regulation D or
adopt an entirely new amendment
under Section 4(2) of the Securities Act,
so that securities sold in reliance on the
138 17
CFR 230.501–508.
Securities Act Rule 501(a) under
Regulation D, 17 CFR 230.501(a).
140 Under Regulation D, investment sophistication
is the ability, acting alone or with the assistance of
others, to understand the merits and risks of making
a particular investment.
141 Under Regulation D as currently in effect,
natural person accredited investors must have a net
worth of $1 million (including property held jointly
with spouse) or $200,000 in individual or $300,000
joint annual income. Rule 501(a)(6).
142 There was support in the subcommittee for
recommending the use of the financial wherewithal
standards for natural person Accredited Investor in
Regulation D for the eligible purchaser standards.
It was our impression from informal discussions
with federal and state regulatory officials that an
increase in the financial wherewithal standards for
natural persons was the sine qua non for obtaining
regulatory support for this proposal.
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new exemption would be ‘‘covered
securities’’ within the meaning of
Section 18 of the Securities Act and
generally exempted from the securities
registration requirements of individual
state securities laws. This course of
action is crucial to the efficacy of the
new exemption.
• The new exemption will need a
two-way integration or aggregation 143
safe harbor similar to that included in
SEC Rule 701.144 Under such a safe
harbor, offers and sales made in
compliance with the new exemption
would not be subject to integration or
aggregation with offers and sales made
under other exemptions or in registered
offerings. Similarly, offers and sales
made under other exemptions or in
registered offerings would not be subject
to integration or aggregation with
transactions under the new exemption.
• As a means of guarding against
potential abuse, we envision that all
solicitations made by means of mass
media (e.g., newspapers, magazines,
mass mailings or the Internet) would be
restricted in scope to basic information
about the issuer, similar to that found in
Securities Act Rule 135c (currently a
permissive rather than restrictive
provision, and one applicable only to
Exchange Act reporting companies).145
Solicitations made in face-to-face
meetings would not be subject to these
restrictions.
The proposed exemption would not
remove the SEC’s authority to regulate
offers of securities. All offering activities
conducted under the new exemption
would continue to be fully subject to the
antifraud provisions of the federal
securities laws. Moreover, disclosure
restrictions modeled after the current
safe harbor found in Rule 135c would
ensure that issuers could not utilize the
Internet, television, radio, newspapers
143 As the Commission is aware, ‘‘integration’’
refers to the SEC doctrine by which all offers and
sales separated by time or other factors are
nevertheless treated as part of a single offering.
Offers and sales believed to be part of separate
offerings that are integrated into a single offering are
required to either comply with a single exemption
from registration or be registered. Otherwise, they
will violate Section 5 and trigger rescission rights
for all purchasers. The SEC integration doctrine
underpins much of the existing Securities Act
registration exemption framework; without it,
evading the Securities Act’s registration
requirements would be possible by artificially
separating an otherwise non-exempt offering into
two more distinct transactions and claiming an
exemption for each transaction.
144 17 CFR 230.701.
145 17 CFR 230.135c. A somewhat similar
structure has been established by the North
American Securities Administrators Association
and adopted in 23 states. See, e.g., Texas
Administrative Code Rule 139.19, which sets forth
the information that can be included in the
announcement.
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and other mass media to engage in
‘‘pump and dump’’ or other
manipulative schemes.
The proposed exemption is not a
radical change in the fundamental
regulatory rationale regarding exempt
private offerings. In all the private
offerings since the beginning of
regulatory time, no offeree has ever lost
any money unless he or she became a
purchaser. The new exemption reduces
the issuer’s obligations regarding noninvestors and refocuses on the need (or
lack thereof) that actual purchasers
have for the protections afforded by the
securities registration process.
We believe that this suggested change
can be viewed as a logical continuation
of an established regulatory trend to
loosen the restrictions on what can be
done with non-purchasers consistent
with investor protection. The SEC has
relaxed restrictions on offers in other,
less bold ways.146 Almost a decade ago,
Linda Quinn, the long-time Director of
the Division of Corporation Finance,
proposed adopting an exemption
substantially similar to that being
recommended.147
146 Rule 254, 17 U.S.C. 230.254, which is
available for use only in Regulation A exempt
offerings, allows issuers before approval of the
offering by the SEC to ‘‘test the waters’’ with
activities that would otherwise be considered
improper advertising or general solicitation;
because of the extremely infrequent use of
Regulation A offerings and an incompatibility with
comparable state securities laws, ‘‘test the waters’’
has been of little practical utility to the capital
formation process. In addition, the SEC staff has
issued interpretive letters advising registered
broker-dealers that certain limited generic
solicitation activities (including Internet-based
solicitation) would not amount to impermissible
advertising or general solicitation. See, e.g.,
Interpretative Letters E.F. Hutton Co. (Dec. 3, 1985),
H.B. Shaine & Co, Inc. (May 1, 1987) and IPOnet
(July 26, 1996). But for these favorable
interpretations, the conduct described in the letters
might have been interpreted as impermissible
advertising and general solicitation. In this regard,
the staff has not extended its interpretation to cover
conduct by issuers (or other non-broker-dealers)
that would allow them to engage in the solicitation
activities described in the broker-dealer
interpretative letters.
147 Expressing her views about securities reform
when she was leaving the staff of the Division of
Corporation Finance, Ms. Quinn endorsed
modifications in the Securities Act exemption
regime consistent with the proposed exemption.
See L. Quinn, Reforming the Securities Act of 1933:
A Conceptual Framework, 10 Insights 1, 25 (Jan.
1996). Ms. Quinn supported the use of ‘‘public
offers’’ in exempt private offerings whose
purchasers were limited to ‘‘qualified buyers’’:
In sum, offers would not be a Section 5 event and
therefore would not be a source of Section 12(1)
liability. * * * Offering communications would
and should still be subject to the antifraud laws.
* * * This approach could be effected by the
Commission defining these communications as
outside the scope of offers for purposes of Section
5 of the Securities Act, subject to conditions
deemed appropriate. The test-the-waters proposal
makes such use of the Commission’s definitional
authority. * * * Id. at 27.
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As a corollary to our recommendation
concerning a lifting of the ban on
general solicitation when sales are made
to certain eligible purchasers who do
not need the full protection of Securities
Act registration, we further recommend
that the Commission relax prohibitions
against general solicitation and
advertising found in Rule 502(c) under
the Securities Act to parallel the ‘‘test
the waters’’ model of Rule 254 under
that Act. Whereas the former would
generally maintain investor protection
by limiting sales of securities to persons
that time and experience have
demonstrated do not need protections
afforded by full registration, this
recommendation would do so by
limiting the information included in a
general solicitation similar to that
allowed in a Regulation A ‘‘test the
waters’’ solicitation.148 Both measures
would, in our view, significantly ease
the difficulties that smaller companies,
the largest users of private offering
exemptions, encounter in locating
suitable investors.
Although we defer to the Commission
as to the exact parameters of permissible
solicitation, we anticipate that any
soliciting materials would be subject to
restrictions modeled on those found in
current Rule 254.149 Issuers would be
required to include disclosure to the
effect that no money or other
consideration is being solicited, that an
indication of interest by a prospective
investor involves no obligation or
commitment of any kind, and that no
sales of securities will be made until
after the suitability of a potential
investor for purposes of the applicable
Regulation D exemption has been
determined. Companies would also be
required to include contact information,
in order to communicate with those
expressing interest and thereafter
establish whether they fit within the
suitability/accreditation standards for
the offering before making a formal offer
of securities, and a disclaimer to the
effect that the offering itself may only be
made to investors that satisfy the
standards of the Securities Act
exemption upon which the company
intends to rely.150 By restricting
148 17
CFR 230.254.
254 was adopted in 1992 and has not
been updated. We recommend that the SEC staff
review the provisions of Rule 254 and harmonize
the recommended changes to take into account the
changes in SEC policy and practice since 1992,
including the SEC’s recently adopted securities
offering reforms.
150 As noted by a former Director of the SEC
Division of Corporation Finance, the use of such
disclaimers is an accepted practice under existing
securities laws: ‘‘Almost all 50 states recognize that
if you advertise on the Internet but disclaim that
you are not selling securities to their residents, and,
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solicitations in this manner, we believe
that much benefit, and very little harm,
would result from a relaxation of the
current advertising/solicitation ban of
Rule 502(c).
As with the recommendation
immediately above, in order to work
effectively the new exemption will need
to be implemented by adoption of a new
or amended rule under Section 4(2) of
the Securities Act, such that securities
sold in reliance on the new exemption
would be ‘‘covered securities’’ within
the meaning of Section 18 of the
Securities Act and consequently
exempted from state securities
registration requirements.
Recommendation IV.P.6
Spearhead a multi-agency effort to
create a streamlined NASD registration
process for finders, M&A advisors and
institutional private placement
practitioners.
As detailed in a recent report
published in the Business Lawyer,151
there exists an unregulated underground
‘‘money finding’’ community that
services companies unable to attract the
attention of registered broker-dealers,
venture capitalists or traditional angel
investors.152 Many smaller companies
rely on this community to assist them in
raising capital. A separate community of
unregistered and therefore unregulated
M&A consultants who assist buyers and
sellers with services and receive
compensation substantially similar to
those provided and earned by
traditional registered investment
bankers also exists. Virtually all of the
in fact, do not sell to their residents, you have not
made an illegal offering in that state. The
Commission has used the same approach for
offerings posted by foreign companies on their web
sites. As long as foreign companies indicate they are
not offering securities to U.S. citizens, their Internet
posting is not an offering in the United States
subject to the registration requirements of the
federal securities laws. Why then prohibit a private
placement as long as (1) it includes a warning that
it will not sell to investors who do not meet the
definition of an accredited investor and (2) does
not, in fact, sell to unsophisticated investors? Who
is harmed?’’ Speech by Brian J. Lane to the
American Bar Association (Nov. 13, 1999),
available at https://www.sec.gov/news/speech/
speecharchive/1999/spch339.htm.
151 Task Force on Private Placement BrokerDealers, ABA Section of Business Law, Report and
Recommendations of the Task Force on Private
Placement Broker-Dealers, 60 Bus. Lawyer 959–
1028 (May 2005), available at https://
www.abanet.org/buslaw/tbl/tblonline/2005_060_03/
home.shtml#1. We note that the Texas State
Securities Board is also drafting a finder proposal.
152 Section 15(a)(1) of the Exchange Act defines
broker-dealers as persons who ‘‘effect any
transaction in, or * * * induce or attempt to induce
the purchase or sale of, any security’’ and makes it
unlawful to carry on broker-dealer activities in the
absence of SEC registration or exemption. Most
state securities laws include similarly broad general
definitions and prohibitions.
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services provided in support of capital
formation and M&A activities amount to
unregistered broker-dealer activities that
violate federal and state broker-dealer
registration and regulation law. For the
most part, the services provided do not
involve holding customers’ funds,
which is a traditional function of many
registered broker-dealers. These
unregulated service providers have a
great reluctance to register as brokerdealers under the current regulatory
framework. The enforcement activity
against them seems minimal. The cost
and administrative burdens of the
current regulatory scheme are daunting
to both the money finding and M&A
communities. The absence of a workable
registration scheme means that issuers
cannot currently use broker-dealer
registration as an element in
differentiating between such providers.
The proposal seeks to foster a scheme of
registration and regulation, substantially
in accordance with the ABA Task Force
Proposal outlined in the Business
Lawyer article referenced above, that
will be cost-effective for the
unregistered community and support
the investor protection goals of
securities regulation.
An unregistered money finder will
never ‘‘come in from the cold’’ to
register if the regulators reserve the right
to institute enforcement actions based
solely on past failure to register.
Accordingly, a workable amnesty
program is also crucial to the success of
the proposal. Regulatory amnesty
should not extend to fraud nor be a
defense against private causes of action.
The private placement broker-dealer
proposal is not new. It has been ‘‘on the
table’’ for a number of years, and
indeed, has been a top recommendation
of the annual SEC Government-Business
Forum on Small Business Capital
Formation for nine of the past ten years.
This demonstrates that other
individuals and groups agree with our
view that this proposal is important to
improve small business capital
formation. To date, however, none of
the affected regulatory bodies have
taken action. We believe the SEC must
provide leadership if this proposal is to
succeed. That leadership must come
first from the Commission itself, and
then the agency must reach out to the
NASD and the state regulators.
Corporate Governance, Disclosure and
Capital Formation—Secondary
Recommendations
In addition to the foregoing primary
recommendations in the area of capital
formation, corporate governance and
disclosure, we also submit for the
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Commission’s consideration the
following secondary recommendations:
Recommendation IV.S.1
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Amend SEC Rule 12g5–1 to interpret
‘‘held of record’’ in Exchange Act
Sections 12(g) and 15(d) to mean held
by actual beneficial holders.153
In order for our recommendation that
the Commission establish a new system
of scaled or proportional securities
regulation for smaller public companies
to apply uniformly and to adequately
protect investors, the rules under which
companies are required to enter and
allowed to exit the underlying
disclosure system must not be subject to
manipulation and circumvention. By
law, companies must enter the system
under Section 12(b) of the Exchange Act
when they register a class of securities
on a national securities exchange, under
Section 12(g) of the Exchange Act when
they have 500 equity shareholders of
record and $10 million in assets, and
under Section 15(d) of the Exchange Act
when they have filed a registration
statement under the Securities Act that
becomes effective.154 Companies may be
entitled to exit the system when their
securities are removed from listing on a
national securities exchange and when
they have fewer than 300, or sometimes
fewer than 500, equity shareholders of
record.155 The rules for entering and
exiting the Exchange Act reporting
system have come into increasingly
sharp focus in recent years, due in part
to the increasing costs associated with
complying with the reporting and other
obligations of reporting companies
under the Exchange Act.
We have concluded that, because of
the way that SEC rules permit the
counting of equity shareholders ‘‘of
record’’ under Exchange Act Rule 12g5–
1,156 circumvention and manipulation
of the entry and exit rules for the SEC’s
public company disclosure system is
possible and occurs. Rule 12g5–1,
which was adopted by the Commission
in 1965, interprets the term ‘‘security
held of record’’ in Section 12(g) for U.S.
companies to include only securities
held by persons identified as holders in
the issuing company’s stock ledger.157
This excludes securities held in street or
nominee name, which is very common
153 Although overall this recommendation passed
unanimously, Messrs. Schacht and Dennis
dissented from the majority vote with respect to
that portion of the recommendation specifying that
holders of unexercised stock options issued in
compliance with Rule 701 not be included as
holders for purposes of Rule 12g5–1.
154 15 U.S.C. 78l(b), 78l(g) & 78o(d).
155 17 CFR 240.12h–3 & 17 CFR 240.12g–4.
156 17 CFR 240.12g5–1.
157 17 CFR 240.12g5–1.
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today, because shares held in street or
nominee name are listed in the stock
ledger as held in the names of brokers,
dealers, banks and nominees. This
interpretation originally was adopted to
simplify the process of determining
whether an issuer is required to report
under Section 12(g).
As noted above, Congress added
Section 12(g) to the Exchange Act in
1964 to extend the reach of most of the
Exchange Act’s public company
reporting and disclosure provisions to
equity securities traded over-the
counter. That provision requires all
companies with a class of equity
securities held of record by at least 500
persons to register with the
Commission.158 Companies registered
with the Commission are required to file
annual and quarterly reports with the
SEC and to comply with the other rules
and regulations applicable to public
companies.159
Exchange Act Rules 12g–4 and 12h–
3 160 regulate when an issuer can exit
the reporting system under Section 12(g)
or Section 15(d). These rules allow an
issuer to terminate its Exchange Act
reporting with respect to a class of
securities held of record by fewer than
300 persons, or fewer than 500 persons
where the total assets of the issuer have
not exceeded $10 million on the last day
of the three most recent fiscal years.
The Nelson Law Firm, on behalf of a
group of institutional investors, recently
filed a rulemaking petition with the SEC
requesting the Commission to take
immediate action to amend Rule 12g5–
1 to count all accounts as holders of
record.161 This petition highlighted the
practice by some issuers of using street
or nominee holders as a technique to
reduce the number of record holders
below 300 and exit the Exchange Act
reporting system. The petition cited
numerous companies that had fewer
than 300 record holders as determined
in accordance with Rule 12g5–1, but
thousands of beneficial owners and total
assets of approximately $100 million or
more. We also received a letter
discussing and supporting the
158 15 U.S.C. 781(g). Section 12(g) does not
require registration if the company does not have
a minimal level of assets. The level was $1 million
in the original statute, but the Commission had
raised the threshold to $10 million by rule by 1996.
See Relief from Reporting by Small Issuers, SEC
Release No. 34–37157 (May 1, 1996) [61 FR 21354].
159 Section 13(a) of the Exchange Act requires
companies registered with the Commission to file
annual and quarterly reports with the SEC.
160 17 CFR 240.12g–4 and 240.12h–3.
161 See Rulemaking Petition of Nelson Law Firm
to SEC (July 3, 2003), available at https://
www.sec.gov/rules/petitions/petn4–483.htm.
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rulemaking petition.162 We received
other letters in support of rulemaking in
this area.163
The trend of going dark is an area of
concern to us. An issuer ‘‘goes dark’’
when holders of record of all classes of
securities fall below the 300 holder
threshold and it files a Form 15
terminating its reporting obligations
under Section 12(g) or suspends its
obligations under Section 15(d).164 This
procedure of going dark is contrasted
with the going private procedures
pursuant to Rule 13e–3.165 Companies
that go private typically buy back
securities from shareholders through an
offering document using Rule 13e–3,
which is filed with the Commission.
When the Commission first adopted
Rule 12g5–1 in 1965, approximately
23.7% of securities were held in
nominee or street name.166 In late 2002,
it was estimated that over 84% of
securities were held in nominee or
street name.167 The Nelson Law Firm
and other proponents of such an
amendment to Rule 12g5–1 believe that
the current definition of ‘‘held of
record’’ allows a company to
162 Letter from Nelson Obus to Committee (Apr.
7, 2005), available at https://www.sec.gov/rules/
other/265–23/26523–1.pdf.
163 Letter from James Brodie to Committee (Apr.
12, 2005), available at https://www.sec.gov/rules/
other/265–23/jabrodie9204.htm; Letter from
Stephen Nelson to Committee (June 8, 2005),
available at https://www.sec.gov/rules/other/265–23/
sjnelson060805.pdf.
164 See Christian Leuz et al., Why do Firms go
Dark? Causes and Economic Consequences of
Voluntary SEC Deregistrations, Wharton Fin’l Inst.
Center Paper No. 04–19 (Nov. 2004), available at
https://fic.wharton.upenn.edu/fic/papers/04/
0419.pdf; see also Andras Marosi & Nadia Massoud,
Why Do Firms Go Dark? (3d ver. Nov. 2004),
available at https://www.umanitoba.ca/faculties/
management/cgafinance/Massoud.pdf#
search=’Andras%20Marosi%20Why%20
firms%20go%20dark%3F.
165 17 CFR 240.13e–3. For a detailed explanation
of going private transactions, see Marc Morgenstern
& Peter Nealis, Going Private: A Reasoned Response
to Sarbanes-Oxley?, (2004), available at https://
www.sec.gov/info/smallbus/pnealis.pdf.
166 Final Report of the Securities and Exchange
Commission on the Practice of Recording the
Ownership of Securities in the Records of the Issuer
in Other than the Name of the Beneficial Owner of
Such Securities Pursuant to Section 12(m) of the
Securities Exchange Act of 1934, at 53–55 (Dec. 3,
1976) (the ‘‘Street Name Study’’).
167 As of June 23, 2004, the DTCC estimated that
approximately 85% of the equity securities listed
on the NYSE, and better than 80% of equity
securities listed on the NASDAQ and AMEX, are
immobilized. See Letter from Jill M. Considine,
Chairman and CEO of DTCC, commenting on
Securities Transaction Settlements, SEC Release No.
33–8398 (Mar. 18, 2004) [69 FR 12922] (on file in
SEC Public Reference Room File No. S7–13–04,
available at https://www.sec.gov/rules/concept/
s71304/s71304–26.pdf. The DTCC immobilization
program is aimed at eliminating physical securities
certificates and its ultimate objective is to place all
equity securities ownership in a direct registration
system which is a street name system.
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manipulate its number of record holders
to circumvent the intent of Section 12(g)
of the Exchange Act.
The substantial increase in securities
held by nominees or in street name has
led to the circumvention of the
intention of Section 12(g) by enabling
issuers with a significant number of
shareholders to avoid registration, or
deregister, if their equity holders are
aggregated into a smaller number of
nominee or record holders.
In light of the above considerations,
we recommend that the Commission
amend Rule 12g5–1 or its interpretation
so that all beneficial owners are counted
for purposes of calculating the number
of shareholders for purposes of Section
12(g) of the Exchange Act and the rules
thereunder. We recommend that the
Commission request its Office of
Economic Analysis or some other
professional organization conduct a
study to determine the effects on the
number of companies required to
register if this recommendation is
adopted. The study should also consider
whether a standard other than number
of shareholders would be a better
determinant of when a company should
be required to enter or allowed to exit
the SEC disclosure system. After the
study is completed, the Commission or
Congress can decide whether the intent
of Section 12(g) would be better served
by changing the number of shareholders
that triggers Exchange Act reporting
from 500 to some other number. We
believe that such a study is important
because of the possibility of
circumvention and manipulation of the
SEC’s rules for entering and exiting the
disclosure system. The significant
increase of costs associated with
compliance with the registration and
ongoing reporting obligations of the
Exchange Act make this issue urgent.
We also received testimony 168
suggesting that employee stock options
(those issued in compensatory
transactions) not be considered a class
of equity securities for purposes of
triggering the registration requirements
under Section 12(g) of the Exchange
Act. We support this view. As
exemplified by the policy underlying
the Rule 701 exemption under the
Securities Act, we believe that holders
of employee stock options received in
compensatory transactions are less
likely to require the full protections
afforded under the registration
requirements of the federal securities
laws. Therefore, we believe that such
168 Record of Proceedings 64 (Sept. 19, 2005)
(testimony of Ann Walker, Esq. before the joint
meeting of the Committee and the Small Business
Forum), available at https://www.sec.gov/rules/
other/265–23/jh-sk-ajm-ayw-gcy091205.pdf.
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stock options should not be a factor in
determining the point an issuer becomes
subject to the burdens of a reporting
company under the Exchange Act.
rather than on brokers and marketmakers.
Recommendation IV.S.2
Make public information filed under
Rule 15c2–11.
A major problem with the market for
over-the-counter securities, where many
issuers are not required to file reports
with the SEC, is the lack of reliable,
publicly available information on
issuers.169 In theory, Exchange Act Rule
15c2–11, which prohibits brokers from
publishing quotations on an OTC
security unless they have obtained and
reviewed current information about the
issuer, could operate as a modest
disclosure system under which
investors could access basic issuer
information if the company is not
required to become a reporting company
under Section 12(g) or 15(d). In practical
terms, however, access to 15c2–11
information is extremely limited.
Broker-dealers are required to file 15c2–
11 information with the NASD only,170
to retain such information in their files
and to provide such information, upon
request, to individual investors. Brokerdealers are not required to publish this
information in a widely available
location or provide it to investors on an
ongoing and systematic basis. The result
is an over-the-counter market in which
the securities of literally thousands of
issuers are traded, but about which
current public information is uneven
and in some cases non-existent. In our
view, these conditions create the
potential for fraud and manipulative
abuse.
In order to address this problem, we
recommend that the Commission take
action to provide for public availability
of Rule 15c2–11 information. Although
we defer to the Commission on the exact
means by which this information would
be made available, we feel that an
orderly and reliable disclosure system
adopted under the SEC’s antifraud
authority could place the burden of
disclosure on issuers, by requiring that
they post a minimal level of
documentation on their company web
site, and on the NASD, by requiring that
it create and maintain an information
repository of Form 211s it has received,
Form a task force, consisting of
officials from the SEC and appropriate
federal bank regulatory agencies to
discuss ways to reduce inefficiencies
associated with SEC and other
governmental filings, including
synchronizing filing requirements
involving substantially similar
information, such as financial
statements, and studying the feasibility
of extending incorporation by reference
privileges to other governmental filings
containing substantially equivalent
information.
We received a number of comment
letters from banks and banking trade
associations expressing concern about
what they consider duplicative filing
requirements of the SEC and other
governmental agencies and the costs
and efficiencies that have resulted.171
Additionally, banks have advised us
that they are subject to duplicative
internal control requirements of various
governmental regulators. We believe
this recommendation is extremely
important. Although we leave it to the
Commission’s discretion as to how best
to implement this recommendation, we
further believe that the introduction of
XBRL may make this recommendation a
more attractive option in today’s world.
We wish to state that in making this
recommendation, we are in no way
advocating an expansion of disclosure
of personal bank information beyond
what is currently permitted.
169 For statistics concerning over-the-counter
issuers not required to file reports with the SEC, see
Appendices I and J.
170 See NASD Rule 6740 (Submission of Rule
15c2–11 Information on Non-NASDAQ Securities).
To demonstrate compliance with both NASD Rule
6740 and SEC Rule 15c2–11, a member must file
with NASD a Form 211, together with the
information required under SEC Rule 15c2–11(a), at
least three business days before the quotation is
published or displayed.
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Recommendation IV.S.3
171 See Record of Proceeding 48 (June 17, 2005)
(testimony of William A. Loving, Chairman and
CEO of Pendleton County Bank representing the
Independent Community Bankers of America);
Letter from Independent Community Bankers of
America to Committee (Mar. 31, 2005), available at
https://www.sec.gov/info/smallbus/acspc/icba.pdf;
Letter from Christopher Cole of Independent
Community Bankers of America to Committee (Apr.
8, 2005), available at https://www.sec.gov/rules/
other/265-23/ccole040805.pdf; Letter from Kathryn
Burns, Vice President and Director of Finance,
Monroe Bank to Committee (May 24, 2005),
available at https://www.sec.gov/rules/other/265-23/
kburns052405.pdf; Letter from Charlotte Bahin,
Senior Vice President, America’s Community
Bankers to Committee (July 19, 2005), available at
https://www.sec.gov/rules/other/265-23/
acbankers071905.pdf; Letter from Mark A.
Schroeder, President and CEO, German American
Bankcorp to Committee (August 3, 2005), available
at https://www.sec.gov/rules/other/265-23/
maschroeder080305.pdf; Letter from Charlotte
Bahin, Senior Vice President, America’s
Community Bankers, to Committee (Aug. 9, 2005),
available at https://www.sec.gov/rules/other/265-23/
cmbahin080905.pdf; Letter from David
Bochnowski, President and CEO of Northwest
Indiana Bancorp to Committee (Aug. 9, 2005),
available at https://www.sec.gov/rules/other/265-23/
dbochnowski080905.pdf.
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Recommendation IV.S.4
Allow companies to compensate
market-makers for work performed in
connection with the filing of a Form
211, with full disclosure of such
compensation arrangements.
The filing of a Form 211, and
compliance with the diligence and
NASD review and comment process that
such a filing entails, generally requires
that a market-maker expend substantial
time, effort and funds. Current NASD
rules, however, prohibit market-makers
from recouping any compensation or
reimbursement for their outlay.172
While acknowledging the need for
restrictions on payments by issuers to
market-makers, we believe that in the
limited context of the Form 211 filing
process, NASD rules act to discourage
market-making activity and impede the
creation of a fair and orderly trading
market in securities of over-the-counter
companies, most of which are smaller
public companies. If Rule 15c2–11 is to
remain focused on broker-dealer rather
than issuer disclosure (see our
recommendation immediately above)
then we recommend that the
Commission encourage the NASD to
modify its rules to allow issuers to
compensate market-makers for work
they perform in connection with the
filing of a Form 211 (including diligence
costs and costs associated with the
NASD review process), if the
compensation arrangement is fully
disclosed. We believe this approach will
encourage dealers to engage in marketmaking and foster a more efficient and
viable market for over-the-counter
securities issuers.
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Recommendation IV.S.5
Evaluate upgrades or technological
alternatives to the EDGAR system so
that smaller public companies can make
their required SEC filings without the
need for third party intervention and
associated costs.
Since the SEC’s EDGAR system 173
was inaugurated in 1993, significant
technological advances have occurred,
including pervasive market deployment
of Internet standards and protocols,
software interoperability and embedded
features. Computers with Internet
capability are available in almost all
172 NASD Rule 2460 (Payments for Market
Making) provides: ‘‘No member or person
associated with a member shall accept any payment
or other consideration, directly or indirectly, from
an issuer of a security, or any affiliate or promoter
thereof, for publishing a quotation, acting as
market-maker in a security, or submitting an
application in connection therewith.’’
173 EDGAR is an abbreviation for the SEC’s
Electronic Data Gathering, Analysis, and Retrieval
System, which must be used by reporting
companies to file their reports with the SEC.
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workplaces and most homes and public
libraries. The EDGAR system has not
been updated to reflect these advances.
Many companies, but especially
smaller public companies, find the
EDGAR system unnecessarily complex
and costly, and usually must engage
costly third party vendors to file their
reports with the Commission. We
believe that the system’s complexity and
cost serves as an unnecessary burden on
capital formation for smaller public
companies.
In this regard, we encourage the
Commission to pursue the use of
Internet standards (e.g., eXtensible
Business Reporting Language, or XBRL)
and protocols (e.g., web services) in the
announced EDGAR modernization
project as a method to reduce costs
associated with the preparation of
registrant filings and the subsequent
access and use of filed information by
the Commission’s staff and the financial
community. We believe that the use of
highly interoperable business reporting
formats will lower information access
costs by the analyst and investor
community and thereby enhance the
analysis and liquidity of the securities
of smaller public companies.
Recommendation IV.S.6
Make it easier for microcap
companies to exit the Exchange Act
reporting system.
As noted elsewhere in this report,174
we have found that the costs associated
with implementing the requirements of
the Sarbanes-Oxley Act are borne
disproportionately by smaller public
companies. For a significant percentage
of companies—particularly those at the
lower end of the market capitalization
spectrum, many of which went public
in the pre-Sarbanes-Oxley era—these
disproportionate costs are compounded
because they enjoy none of the
traditional benefits of being public: their
stock receives little or no analyst
coverage, has a limited trading market,
provides limited liquidity for their
shareholders, and attracts little
institutional investment. They also
experience a diminished ability to gain
access to investment capital in the
public markets, particularly during a
market downturn. For such companies,
the burdens of public company status
may far outweigh the benefits.
At the same time, current SEC
regulations require companies that wish
to go private to submit to a lengthy SEC
review process, in which a company
must provide detailed disclosure as to
174 See discussion under the caption ‘‘Part II.
Scaling Securities Regulation for Smaller
Companies.’’
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the fairness of the transaction. The going
private process generally includes the
participation of investment banking
firms, law firms and accountants, and
hence results in substantial transaction
costs.
While the significance of the
transaction and the possibility for
conflicts of interest and insider abuse in
a true ‘‘going private’’ transaction (i.e.,
one in which a controlling group
undertakes a corporate transaction in
order to acquire the entire equity
interest in a corporation) justify this
heightened scrutiny, the Committee
believes that microcap companies that
wish to go dark should be entitled to a
simplified SEC review process
conditioned on the issuer undertaking
to provide the remaining shareholders
with periodic financial and other
pertinent information, such as
unaudited quarterly financial
statements, annual GAAP audited
financial statements and narrative
information about basic corporate
governance, executive compensation
and related party transactions as long as
their shares trade in a public market.
This approach would ensure that
investors in such companies receive
information necessary for operations
transparency and protection of their
interests.
Recommendation IV.S.7
Increase the disclosure threshold of
Securities Act Rule 701(e) from $5
million to $20 million.
The SEC adopted Rule 701 in April
1988 to provide an exemption from the
registration requirements under the
Securities Act for offers and sales of
securities by non-reporting companies
to their employees. The Commission
amended Rule 701 in 1999 to, among
other things, replace the fixed aggregate
$5 million offering ceiling contained in
the original rule with a more flexible
limit that required, among other items,
disclosure of financial statement and
risk factor information if the aggregate
amount of securities sold under Rule
701 exceeded $5 million in any 12month period.
Over time, Rule 701 has proved to be
an extraordinarily useful exemption for
both small businesses and large private
companies, and for the most part
continues to work well. Nonetheless,
the disclosure of financial statement
information has been problematic for
growing companies in recent years as a
result of the recent trend towards longer
IPO incubation periods, particularly in
a ‘‘down’’ market environment, as well
as the increased use of equity awards as
an incentive for attracting/retaining
employees. For private companies that
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hope to maintain the confidentiality of
their financial information for
competitive reasons, the increasing need
for equity compensation presents a
dilemma: Disclose such information,
and expose yourself to potential
competitive harm (particularly relative
to other private companies that are not
required to disclose such information),
or restrict equity awards to a limit below
that which business conditions and
sound judgment might otherwise
dictate.
Based on the foregoing, we believe
that an increase in the disclosure
threshold of Rule 701(e) to $20 million
represents a more appropriate balance
between the informational needs of
employee-investors and the
confidentiality needs of private
company issuers. The $5 million
threshold was actually established in
1988, based upon the Commission’s
small issue exemptive limit at the
time.175 The Committee’s proposed
increase would account for the amount
of the original threshold that has been
diminished due to inflation (as a point
of reference, $5 million in 1988 would
equal approximately $8.35 million
today) as well as provide issuers with
increased flexibility for granting equity
awards without compromising
confidentiality.
In the event that the Commission
finds such increase in the disclosure
threshold to be inadvisable, we
recommend as an alternative that the
financial statement disclosure
requirements be eliminated or modified
significantly if (1) options are nontransferable except by law and (2)
options may only be exercised on a
‘‘net’’ basis with no employee funds
paid to the issuer/employer.
Recommendation IV.S.8
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Extend the ‘‘access equals delivery’’
model to a broader range of SEC filings.
Since 1995, the Commission has
published guidance regarding the
electronic delivery of materials under
the federal securities laws.176 Recent
studies indicate that 75% of Americans
have access to the Internet in their
homes, and that this percentage is
175 Rule 701 was originally adopted under
Securities Act Section 3(b), which has a $5 million
limit, but was re-adopted in 1999 under Securities
Act Section 28, which was no such limit. See Rule
701—Exempt Offerings Pursuant to Compensatory
Arrangements (Mar. 8, 1999) [64 FR 11095].
176 Use of Electronic Media for Delivery Purpose;
Action: Interpretation; Solicitation of Comment,
SEC Release No. 33–7233 (Oct. 6, 1995) [60 FR
53458], provided the initial guidance on electronic
delivery of prospectuses, annual reports, and proxy
materials under the Securities and Exchange Acts.
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increasing steadily among all age
groups.177
The SEC recently has taken several
steps to facilitate electronic delivery of
filed documents filed with the Agency.
In connection with the recent Securities
Offering Reform effort, the Commission
adopted Securities Act Rule 172
implementing an ‘‘access equals
delivery’’ model in the context of final
prospectus delivery. The Commission
has also recently proposed a rule
facilitating the electronic delivery of
proxy materials.178 In that release, the
Commission stated that its members
‘‘believe that continuing technological
developments and the expanded use of
the Internet now merit consideration of
alternative methods for the
dissemination of proxy materials.’’ 179 In
the access equals delivery model
investors would be assumed to have
access to the Internet thereby allowing
delivery to be accomplished solely by
an issuer posting a document on the
issuer’s or third party’s Web site. This
presumption differs from the current
consent model where an investor must
affirmatively consent to receiving
documents electronically.
We strongly support the proposed
amendments to the proxy delivery rules.
We believe these changes will reduce
the printing and mailing costs
associated with furnishing proxy
materials to shareholders, while not
impairing investor protection, as
shareholders desiring paper versions of
such documents are able to obtain them
at no cost under the proposal. We
believe, however, that the Commission
should go further and recommend that
the Commission extend the access
equals delivery model for delivery to all
SEC filings, thereby providing the
efficiencies and cost savings of
electronic delivery to all documents
required to be delivered under the
federal securities laws. The only
exception to our recommendation is
delivery of preliminary prospectuses in
initial public offerings in Rule 15c2–
8.180
177 See Internet Availability of Proxy Materials,
SEC Release No. 34–52926 (Dec. 8, 2005) [70 FR
74597], citing Three Out of Four Americans Have
Access to the Internet, Nielson/NetRatings (Mar. 18,
2004).
178 Id.
179 See Acceleration of Periodic Report Filing
Dates and Disclosure Concerning Website Access to
Reports, SEC Release No. 34–46464 (Apr. 8, 2003)
[67 FR 58480]; Acceleration of Periodic Report
Filing Dates and Disclosure Concerning Website
Access to Reports; Correction, SEC Release No. 34–
46464A (Sept. 5, 2003) [67 FR 17880].
180 17 CFR 240.15c2–8.
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11119
Recommendation IV.S.9
Shorten the integration safe harbor
from six months to 30 days.181
The concept of integration, discussed
above,182 has been the subject of intense
criticism, almost since its inception,183
and small business issuers and their
legal advisors have long expressed
concerns about the absence of clarity in
being able to determine the
circumstances under which integration
does (or does not) apply. Though the
SEC attempted to introduce more
certainty into the determination by
introduction of a five-factor test in
1961,184 as a practical matter the
question of integration remains for
smaller companies an area fraught with
uncertainty—and therefore risk.185
Because of the link between
integration and the availability of
Regulation D and other registration
exemptions, and consequently the
ability of a smaller company to
undertake a private financing, we
believe that the SEC should provide
smaller companies with clearer
guidance concerning the circumstances
under which two or more apparently
separate offerings will or will not be
integrated. After considering the
difficulties of modifying the five-factor
test in order to encompass the entire
range of potential offering scenarios, we
concluded that shortcomings of the
existing framework can most easily be
addressed by shortening the six-month
safe harbor of Regulation D and
applying the shortened safe harbor
across the entire universe of private
offering exemptions.
The Regulation D safe harbor provides
generally that offers and sales made
more than six months before the start of
181 Although the Committee is recommending a
30-day period, we are flexible in this regard.
182 See text accompanying note 208.
183 See Stanley Keller, Basic Securities Act
Concepts Revisited, Insights (May 1995).
184 See, e.g., Perry E. Wallace, Jr., Integration of
Securities Offerings: Obstacles to Capital Formation
Remain for Small Business, 45 Wash. & Lee L. Rev.
935, 937, 972–975 (1988) (integration doctrine
‘‘frustrates issuers engaged in the capital formation
process, engulfing them in a sea of ambiguity,
uncertainty and potential liability’’ and ‘‘of the
various sources of angst facing the small issuer,
none has proved more frustrating and elusive than
the doctrine of integration of securities offerings’’).
Faced with these difficulties, academics and
practitioners have long argued for change to the
existing system, with some even arguing that the
very concept of integration should be abolished. In
our view, however, this goes too far, as issuers
could then split their offerings among several
different exemptions, thus vitiating the registration
process upon which the Securities Act is premised.
185 The confusion over making an integration
determination is made more difficult because the
SEC staff does not currently render advice or
provide no-action relief concerning integration
questions.
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a Regulation D offering or more than six
months after completion of a Regulation
D offering will not be considered part of
that Regulation D offering.186 The safe
harbor is particularly significant for
smaller companies, who rely heavily on
Regulation D exemptions. Although it
provides certainty, however, the safe
harbor does so at the expense of
flexibility, as it requires that as much as
a full year elapse between offerings. For
smaller companies, whose financing
needs are often erratic and
unpredictable, the duration of the safe
harbor period is often problematic; even
a well meaning issuer that needs access
to capital, because of changed
circumstances or greater than
anticipated need for funding, may be
unable to access such funds without
running afoul of Section 5.
Inasmuch as the alternative to the safe
harbor is the inherent uncertainty of the
five-factor test, the practical effect of the
waiting period between Regulation D
offerings is to undermine issuers’
flexibility and impede them from
obtaining financing at a time that
business goals, and good judgment,
would otherwise dictate.
In short, we believe that the dual sixmonth safe harbor period represents an
unnecessary restriction on companies
that may very well be subject to
changing financial circumstances, and
weighs too heavily in favor of investor
protection, at the expense of facilitating
capital formation. We believe that a
shorter safe harbor period between
offerings of 30 days strikes a more
appropriate balance between the
financing needs of smaller companies
and investor protection, while
preserving both investor protection and
the integrity of the existing registration/
exemption framework.
Recommendation IV.S.10
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Clarify the Sarbanes-Oxley Act
Section 402 loan prohibition.
Section 402, of the Sarbanes-Oxley
Act, which added Section 13(k) 187 to
the Exchange Act, prohibits public
companies from extending personal
loans to directors or executive
186 Rule 502(a) provides in pertinent part: ‘‘Offers
and sales that are made more than six months
before the start of a Regulation D offering or are
made more than six months after completion of a
Regulation D offering will not be considered part of
that Regulation D offering, so long as during those
six month periods there are no offers or sales of
securities by or for the issuer that are of the same
or a similar class as those offered or sold under
Regulation D, other than those offers or sales of
securities under an employee benefit plan as
defined in Rule 405 under the Act, 17 CFR
230.405.’’
187 15 U.S.C. 78m(k).
187 17 CFR 230.405.
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officers.188 The prohibition was enacted
following abuses associated with
company loans in several wellpublicized corporate scandals. To date,
the SEC’s Division of Corporation
Finance has not provided interpretive
guidance with respect to Section 13(k).
We believe that confusion exists among
public companies and their attorneys
concerning the applicability of the loan
prohibition to a number of transactions
that could be construed as loans.
We strongly support the loan
prohibition contained in Section 13(k)
of the Exchange Act. We recommend
that the SEC staff seek to provide
clarifying guidance as to the types of
transactions that fall outside the
prohibition.
In particular, we recommend that the
SEC’s Division of Corporation Finance
clarify whether Section 13(k) prohibits
the cashless exercise of stock options,
indemnity advances, relocation
accommodations to new hires and split
dollar life insurance polices. We believe
that these transactions, if approved by
independent directors, are unlikely to
lead to the abuses envisioned under
Section 402 of the Sarbanes-Oxley Act.
Recommendation IV.S.11
Increase uniformity and cooperation
between federal and state regulatory
systems by defining the term ‘‘qualified
investor’’ in the Securities Act and
making the NASDAQ Capital Market
and OTCBB stocks ‘‘covered securities’’
under NSMIA.
In fulfillment of our basic mandate—
to identify methods of minimizing costs
and maximizing benefits—we believe it
is important to increase uniformity and
cooperation between federal and state
securities regulatory systems by
eliminating unnecessary and
duplicative regulations.
In our view, this can be accomplished
by both (1) defining ‘‘qualified
purchaser’’ as permitted by the National
Securities Markets Improvement Act of
1996,189 or NSMIA, allowing
transactions to involve ‘‘covered
securities’’ and (2) making NASDAQ
Capital Market and OTCBB stocks
‘‘covered securities,’’ thereby
preempting most state securities
registration provisions.
In connection with its passage of
NSMIA, Congress authorized the SEC to
define the term ‘‘qualified purchaser’’
under Securities Act Section 18 to
include, among others, ‘‘sophisticated
investors, capable of protecting
themselves in a manner that renders
regulation by state authorities
188 Pub.
189 Pub.
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L. No. 104–290, 110 Stat. 3416 (1996).
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unnecessary.’’ Section 18 also provides
that sales to ‘‘qualified purchasers’’ are
by definition ‘‘covered securities.’’ The
effect of defining ‘‘qualified
purchasers,’’ therefore, would be to
exempt offers and sales to persons
included in the definition from
unnecessary state registration
requirements.
The Commission in 2001 issued a
release in which it proposed to define
‘‘qualified purchaser’’ to have the same
meaning as the term ‘‘accredited
investor’’ under Rule 501(a) of
Regulation D.190 Although the
Commission solicited comment from
interested parties, it took no further
action on the proposal, in part because
of the opposition of state securities
regulators.191
The Committee applauds the SEC’s
initiative in issuing the qualified
purchaser release, and recommends that
the ideas expressed in the release,
principally, that all ‘‘accredited
investors’’ be deemed ‘‘qualified
purchasers,’’ be adopted substantially as
proposed. The release states, and we
agree, that defining ‘‘qualified
purchaser’’ to mean ‘‘accredited
investor’’ would strike the appropriate
balance between the need for investor
protection and meaningful regulatory
relief from duplicative state regulation
for issuers offering securities, in
particular small businesses.192 Investor
protection would be maintained, as
accredited investors have long been
deemed not to require the full
protection of Securities Act registration
and have sufficient bargaining power to
gain access to information with which
to make informed investment decisions.
As the Commission is aware, in 1996
NSMIA realigned the relationship
between federal and state regulation of
the nation’s securities markets in order
to eliminate duplicative costs and
improve market efficiency, while
maintaining necessary investor
protections. Although NSMIA greatly
benefited large businesses, it had a more
limited effect on small businesses, the
securities of many of which trade on the
NASDAQ Capital Market and the
OTCBB and consequently do not qualify
for the favorable exemptive treatment
accorded ‘‘covered securities.’’ For these
smaller public companies, the added
190 Defining the Term ‘‘Qualified Purchaser’’
Under the Securities Act, SEC Release No. 33–8041
(Dec. 19, 2001) [66 FR 66839].
191 See, e.g., Letter from Joseph P. Borg, NASAA
President and Director, Alabama Securities
Commission, on behalf of the North American
Securities Administrators Association to Committee
(Mar. 4, 2002), available at https://www.sec.gov/
rules/proposed/s72301.shtml.
192 Supra note 190, at 4.
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burden, complexity and transaction
costs that result from a need to comply
with numerous sets of laws and
regulations, rather than just one, places
them at a distinct disadvantage in
comparison with their larger
counterparts.
In our view, the two-tiered regulatory
structure to which the NASDAQ Capital
Market and OTCBB–traded securities
are subject represents an unnecessary
and duplicative level of regulation that
impedes the free flow of capital, while
adding little in terms of investor
protection. All companies traded in
both markets are required to be
Exchange Act reporting companies.
Therefore, we recommend that the
Securities Act Section 18(b) definition
of ‘‘covered securities’’ be expanded to
include the shares of all NASDAQ
Capital Market and OTCBB issuers,
provided that such companies (1) are
current in their Exchange Act filings
and (2) adhere to the corporate
governance standards, detailed in Part
III of this Committee report, that
companies would be required to observe
in order to get relief from certain
requirements of Sarbanes-Oxley Act
Section 404. We believe that this action
would be consistent with the sentiment
expressed in Securities Act Section
19(d), which mandates greater federal
and state cooperation in securities
matters in order to provide both
maximum uniformity in federal and
state regulatory standards and to
minimize interference with capital
formation. Further, investor protection
would be preserved, as states would
retain their anti-fraud authority and the
SEC would maintain its supervisory role
through review of issuer registration
statements and Exchange Act filings.
A final word should be said
concerning the manner in which this
recommendation is implemented.
Although not entirely clear, it appears
that the express language of Section 18
may not provide the Commission with
the authority to expand the definition of
‘‘covered securities’’ to encompass
NASDAQ Capital Market and OTCBB
securities without further Congressional
action. In such event, we recommend
that the Commission petition Congress
to enact legislative changes to Section
18 in order to effect such changes.
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Recommendation IV.S.12
Clarify the interpretation of or amend
the language of the Rule 152 integration
safe harbor to permit a registered initial
public offering to commence
immediately after the completion of an
otherwise valid private offering the
stated purpose of which was to raise
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capital with which to fund the IPO
process.
Rule 152 provides an integration safe
harbor that protects against integration
of a private offering followed closely by
a registered public offering. By its terms,
the language of Rule 152 appears to
require that an issuer ‘‘decide’’ to file for
the public offering after the private
offering.193 In other words, the safe
harbor protection from integration
would not appear to be available to an
issuer that contemporaneously plans a
private placement (for among other
reasons, to raise funds necessary to
sustain it through the IPO process) and
a subsequent registered offering.
Moreover, Rule 152 does not apply to
private offerings undertaken pursuant to
Rules 504 or 505, which are exempt
pursuant to Securities Act Section 3(b),
not Section 4(2) as set forth in the rule.
Although the staff of the Division of
Corporation Finance has indicated that
it does not interpret Rule 152 literally,
and will extend safe harbor treatment
even in cases where an issuer
concurrently plans a private placement
and registered offering,194 we believe
that it is time to clarify or amend the
language of the rule appropriately.
Part V. Accounting Standards
We devoted a considerable amount of
time and effort surveying the current
state of U.S. GAAP that apply to smaller
public companies and certain of the
processes related to the audits of their
financial statements. In general, we
believe that current regulations and
processes in these areas serve smaller
public companies and their investors
very well. We did, however, identify
several concerns in this area which, we
acknowledge, are not all unique to
smaller public companies. In decreasing
order of concern, these areas are:
• Complexity of current accounting
standards;
• Diminished use and acceptance of
professional judgment because of fears
of being second-guessed by regulators
and the plaintiffs bar;
• Perception of lack of choice in
selection of an audit firm;
• Lack of judgment concerning
application of auditor independence
rules; and
• Lack of professional education
requirements covering SEC reporting
193 Rule 152 provides as follows: ‘‘The phrase
‘transactions by an issuer not involving any public
offering’ in Section 4(2) shall be deemed to apply
to transactions not involving any public offering at
the time of said transaction although subsequently
thereto the issuer decides to make a public offering
and/or files a registration statement.’’ 17 CFR
230.152.
194 See, e.g., SEC No Action Letter, Verticom, Inc.
(Feb. 12, 1986).
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matters for auditors of public
companies.
Accounting Standards—Primary
Recommendations
We recommend that the Commission
and other bodies, as applicable,
effectuate the following:
Recommendation V.P.1
Develop a ‘‘safe-harbor’’ protocol for
accounting for transactions that would
protect well-intentioned preparers from
regulatory or legal action when the
process is appropriately followed.
This recommendation represents an
attempt by us to address the diminished
use of professional judgment caused in
part by fears of second-guessing by
regulators and the plaintiff’s bar. This is
a very serious issue for smaller public
companies. Testimony taken by us, as
well as written communications we
received, strongly supported this view.
Accounting standards for public
companies vary in nature, ranging from
standards containing principles and
implementation guidance on broad
accounting topics to those containing
guidance pertaining to specific business
transactions or industry events. Even
with the broad spectrum of existing
accounting standards, transactions or
other business events frequently arise in
practice for which there is no explicit
guidance. In these situations, public
companies and their auditors consider
other relevant accounting standards and
evaluate whether it would be
appropriate to apply the guidance in
those standards by analogy. Preparers
often find it difficult to make these
determinations, particularly in new or
emerging areas. Even when accounting
guidance is applied by analogy,
questions frequently arise as to whether
the analogy is appropriate based on a
company’s particular facts and
circumstances. The result is that
companies frequently end up adopting
an approach dictated by their auditors,
which the companies believe is caused
by their auditors’ concerns about
regulators questioning their judgments,
or for other reasons.
In view of this situation, we are
recommending that a ‘‘safe-harbor’’
protocol be developed that would
protect well-intentioned preparers from
regulatory or legal action when a
prescribed process is appropriately
followed and results in an accounting
conclusion that has a reasonable basis.
A possible outline for the protocol for
the preparer to follow would be as
follows:
• Identify all relevant facts.
• Determine if there is appropriate
‘‘on-point’’ accounting guidance.
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• If no on-point guidance exists,
develop and timely document the
preparer’s conceptual basis for their
conclusion as to the appropriate
accounting treatment.
• Determine and timely document
how the proposed accounting treatment
reflects the economic realities of the
transaction.
• Disclose in the financial statements
and in Management’s Discussion &
Analysis the nature of the transaction,
the possible alternative accounting
treatments, and the rationale for the
approach adopted.
We believe that a ‘‘safe harbor’’
approach is suitable for dealing with
this problem. In general, a safe harbor
provision in a law serves to excuse
liability if an attempt to comply in good
faith can be demonstrated. Safe harbor
provisions are used in many areas of the
federal securities laws. One well-known
safe-harbor that may serve as a model
for crafting a safe-harbor for accounting
transactions is the safe-harbor for
forward-looking statements under the
Private Securities Litigation Reform Act
of 1995. The PSRLA provides a safe
harbor from liability in private claims
under the Securities Act and Exchange
Act to a reporting company, its officers,
directors and employees, as well as
underwriters, for projections and other
forward-looking information that later
prove to be inaccurate, if certain
conditions are met. The PSLRA’s safeharbor was based on aspects of SEC
Rule 175 under the Securities Act and
Rule 3b–6 under the Exchange Act.195
Both of these rules, adopted in 1979,
provide a safe-harbor for certain
forward-looking statements published in
documents filed with the SEC, provided
the filer had a reasonable basis to make
the statement and was acting in good
faith. By combining aspects of, but not
eliminating, Rules 175 and 3b–6 with
the judicially created ‘‘bespeaks
caution’’ doctrine, Congress created a
statutory safe-harbor based on the belief
that the existing SEC rule-based and
judicial safe-harbor protections did not
provide adequate protections to
reporting companies from abusive
private securities litigation.196
195 17
CFR 230.175, 240.3b–6.
PSLRA provides a safe-harbor from
liability under the Securities Act and Exchange Act
to the reporting company, its officers, directors,
employees and underwriters, if the forward-looking
statements later prove to be inaccurate, if:
1. The forward-looking statement is identified as
such and is accompanied with meaningful
cautionary statements identifying important factors
that could cause actual results to differ materially;
or
2. The forward-looking statement is immaterial;
or
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We believe that implementation of
this recommendation has the potential
to assist smaller public companies when
working with their audit firms and other
parties involved in the financial
reporting system. This, in turn, should
reduce excessive and unnecessary
regulatory burdens on smaller public
companies.
We do not believe that
implementation of our recommendation
would fully address the diminished use
of professional judgment due to fears of
being second-guessed. This is a deep
seated problem related to the excessive
litigiousness of our society.197
Accordingly, we urge the Commission,
other regulators and federal and state
legislators to continue to search for
appropriate and effective ways to lessen
this problem and reduce unnecessary
regulatory burdens on smaller
companies.
Recommendation V.P.2
In implementing new accounting
standards, the FASB should permit
microcap companies to apply the same
extended effective dates that it provides
for private companies.
New accounting standards typically
introduce new accounting requirements
or change existing requirements. In
order to allow sufficient time for
companies to gather information
required by the new accounting
standards, the FASB does not require
new standards to be effective
immediately upon issuance. Instead, the
FASB establishes a date in the future
when the accounting standards should
be adopted, or become effective. The
amount of time allowed by the FASB
between the issuance of a new standard
and its effective date varies and depends
on the nature of the accounting
requirements and the number of
companies impacted. In addition, the
FASB may establish different effective
dates for private companies and public
companies.198
3. The plaintiff fails to prove the statement was
made with actual knowledge that it was materially
false or misleading.
See Jay B. Kasner, The Safe Harbor for ForwardLooking Statements Under the Private Securities
Litigation Reform Act of 1995, Practising Law
Institute (Sept. 2000); See also Stephen J. Schulte
and Alan R. Glickman, Safe Harbors for ForwardLooking Statements: An Overview for the
Practitioner, Practising Law Institute (Nov. 1997).
197 See Record of Proceedings 95–100 (June 16,
2006) (statements of George Batavick, Adv. Comm.
Observer, and Mark Jensen, Adv. Comm. Member,
on the importance of tort reform to reduce litigation
costs and facilitate a return to principles-based
accounting).
198 FASB standards that distinguish between
private and public companies usually define those
terms. For examples where the FASB has deferred
the effective dates for non-public entities, as
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In some cases, a company will need
to gather and analyze a significant
amount of information in order to adopt
an accounting standard. Smaller public
companies oftentimes may not have the
resources of larger companies to assist
with this effort.199 For example,
companies may not have sufficient
information technology or valuation
specialists on staff and would need to
consider hiring external parties. In
addition, as business transactions have
become more complex in recent years,
accounting standards also have become
more complex, requiring greater study
and expertise by the preparers and
auditors’ of financial statements.200
We note that some of the more
complicated accounting standards
recently issued by the FASB permit
private companies an extended period
of time in which to adopt the new
standard.201 We believe that allowing
microcap companies more time to
implement new accounting standards is
appropriate. We are recommending that
microcap companies be allowed to
apply the same effective dates that the
FASB provides for private companies in
implementing new accounting
standards. The Committee considered
and rejected the notion that smallcap
companies, in addition to microcap
companies, also should be allowed
extended effective dates. We believe
that, in general, smallcap companies
have more resources than microcap
companies and should be able to adopt
new accounting standards on the same
time line as larger public companies.
While making this recommendation,
we do not propose to establish different
accounting standards for smaller and
larger public companies. Primarily
through our Accounting Standards
Subcommittee, we considered the socalled Big GAAP versus Little GAAP
debate. This debate involves the
advisability of adopting two different
accounting standards for smaller and
larger public companies, and whether
U.S. GAAP should be made scalable for
smaller public companies. The
defined therein, see FASB Statement of Financial
Accounting Standards No. 150, Accounting for
Certain Financial Instruments with Characteristics
of both Liabilities and Equity ¶ 29 (May 2003) and
FASB Staff Position 150–3 (Nov. 2003).
199 See Letter from Ernst & Young LLP to
Committee (May 31, 2005); Letter from American
Bankers Association to Committee (Aug. 31, 2005).
200 See Letter from BDO Seidman, LLP to
Committee (May 31, 2005).
201 See Statement 150, paragraph 29. See also
FASB Statement of Financial Accounting Standards
No. 123, Share-Based Payment § 69, B248 (revised
2004) (permitting small business issuers, as defined,
to defer adoption of the standard on the basis that
those companies may have fewer resources to
devote to implementing new accounting standards
and thus may need additional time to do so).
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Committee considered whether the
needs of users of smaller public
company financial statements are
different from the needs of users of
larger public company financial
statements, whether smaller public
companies incur disproportionate costs
to provide certain financial information,
and whether such information is
actually used. The Committee discussed
whether smaller public companies
should have accounting standards with
recognition, measurement and/or
disclosure requirements that are
different from those of larger public
companies, and whether unintended
adverse consequences would result from
having two sets of GAAP.
We have determined that different
accounting standards should not be
created for smaller and larger public
companies. We believe such an
approach would confuse investors and
that, in many cases, the financial
community would require smaller
public companies to follow the more
stringent accounting standards
applicable to larger companies. We
believe that if a two-tiered system of
accounting standards existed, many
smaller public companies would
voluntarily follow the more stringent
standards, so as not to be perceived as
less sophisticated. We also believe that
two different accounting standards for
public companies would add significant
costs to the financial reporting system
and could potentially increase the cost
of capital to smaller public companies,
as risk premiums could attach to what
might be perceived as less stringent
accounting standards.202 Finally, we did
not see evidence of any overwhelming
support for a two-tiered system of
accounting standards in the written and
oral submissions we received.203
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Recommendation V.P.3
Consider additional guidance for all
public companies with respect to
202 See, e.g., Letter from Council of Institutional
Investors to Committee (Aug. 26, 2005).
203 See Record of Proceedings 24–26, 42 (Oct. 14,
2005) (testimony of Jane Adams, Maverick Capital
Ltd., New York, New York, stating that companies
by virtue of size should not be able to choose among
multiple GAAP’s to structure transactions and keep
relevant information from investors, and if different
standards are permitted, whether GAAP or internal
controls, any financial statements and filings
prepared under this light version should warn
investors that this information did not come with
the full package of protections and controls). See
also Letter from PricewaterhouseCoopers LLP to
Committee (Sept. 2, 2005); Letter from Grace &
White, Inc. to Committee (Oct. 6, 2005); Letter from
Glass Lewis & Co. to Committee (Sept. 14, 2005).
See also responses to Questions 16 and 21 of
Request for Public Input by Advisory Committee on
Smaller Public Companies, SEC Release No. 33–
8599 (Aug. 5, 2005) available at https://
www.sec.gov/rules/other/265-23survey.shtml.
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materiality related to previously issued
financial statements.
We heard testimony related to a
recent increase in financial statement
restatements for previously undetected
accounting errors.204 The Committee is
concerned that these restatements are
occurring where the impact of the error
is not likely to be meaningful to a
reasonable investor. The determination
as to whether an event or transaction is
material to the financial statements can
be highly subjective and judgmental.
One source of information for public
companies to consider when making
this determination is SEC Staff
Accounting Bulletin No. 99, Materiality
(SAB 99). SAB 99 expresses the staff’s
views regarding reliance on certain
quantitative benchmarks to assess
materiality in preparing financial
statements and performing audits of
those financial statements. One issue
that is not addressed in SAB 99 relates
to the assessment of materiality in
quarterly reporting periods, including
quarterly reporting periods of
previously reported annual periods. We
discussed whether one reason for these
restatements might be the lack of
guidance pertaining to assessing
materiality in quarterly periods.
We recommend that the SEC consider
providing additional guidance for all
public companies with respect to
materiality related to previously issued
financial statements, to ensure that
investor confidence in the U.S. capital
markets is not being adversely impacted
by restatements that may be
204 Record of Proceedings 30–31 (Sept. 19, 2005)
(testimony of Lynn E. Turner, Managing Director of
Research, Glass Lewis & Co., noting that Huron
Consulting Group reported that 75% of the
restatements over the last five years have come from
small companies); Record of Proceedings 105 (Sept.
19, 2005) (testimony of Michael McConnell,
Managing Director, Shamrock Capital Advisors,
Burbank, Calif., citing several studies that show half
to three quarters of the restatements of public
companies in the last several years have been by
companies with either revenues under a half billion
or market cap under $100 million). But see Record
of Proceedings 108 (Sept. 19, 2005) (statement of
Robert E. Robotti, Adv. Comm. Member, noting that
the amount of restatements by smaller companies
is proportionate to that of larger companies, since
microcap companies represent 50% of all public
companies). Institutional investor advisory firm
Glass, Lewis & Co. estimates that a record 1,200 of
the total 15,000 public companies will have
announced accounting restatements by the time
annual reports are filed for 2005. This compares
with 619 restatements in 2004, 514 in 2003, 330 in
2002 and 270 in 2001, the year before the SarbanesOxley Act was passed. The threat of criminal
penalties for executives and the focus on internal
controls by the Sarbanes-Oxley Act has created an
environment of second-guessing by auditors, where
minor accounting errors can now result in a full
investigation of a company’s accounting
procedures. Excavations in Accounting: To Monitor
Internal Controls, Firms Dig Ever Deeper Into Their
Books, Wash. Post, Jan. 30, 2006, at D1.
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unwarranted. Two specific fact patterns
should be considered in developing
additional guidance:
• The effect of the previously
undetected error is not material to any
prior annual or quarterly financial
statements, the effect of correcting the
cumulative error is not expected to be
material to the current annual period,
but the impact of correcting the
cumulative error is material to the
current quarter’s financial statements. In
this circumstance, we recommend the
SEC consider whether the appropriate
treatment would be to correct the
cumulative error in the current period
financial statements, with full and clear
disclosure of the item and its impact on
the current quarter, with no restatement
of prior year or quarterly financial
statements. We believe this treatment is
consistent with the guidance in
paragraph 29 of Accounting Principles
Board Opinion No. 28, Interim Financial
Reporting.205
• The effect of a previously
undetected error is not material to the
financial statements for a prior annual
period, but is material to one or more of
the quarters within that year. In
addition, the impact of correcting the
cumulative error in the current quarter’s
financial statement would be material to
the current quarter, but is not expected
to be material to the current annual
period. In this circumstance, we
recommend the SEC consider whether
the appropriate treatment would be the
same as described above since the
impact on the previously issued annual
financial statements is not material. In
this event, full disclosure in the current
quarter financial statements should be
required.
Recommendation V.P.4
Implement a de minimis exception in
the application of the SEC’s auditor
independence rules.
The Commission’s rules on the
independence of public company
auditors include a general standard of
auditor independence.206 In
determining whether a relationship or
provision of a service not specifically
prohibited by the rules impairs the
auditor’s independence, four principles
must be considered.207 The
205 The Accounting Principles Board (APB) was
the predecessor entity to the FASB.
206 The most recent revision to the auditor
independence rules occurred in Jan. 2003. See
Strengthening the Commission’s Requirements
Regarding Auditor Independence, SEC Release No.
33–8183 (Jan. 28, 2003) (68 FR 6006).
207 See Remarks by Edmund W. Bailey, Senior
Associate Chief Accountant, U.S. Securities and
Exchange Commission, Before the 2005 AICPA
National Conference on Current SEC and PCAOB
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Commission’s rules also set forth
specific prohibitions on financial,
employment, and business relationships
between an auditor and an audit client,
as well as prohibitions on an auditor
providing certain non-audit services to
an audit client, and augment the general
standard and related principles.208 One
of the principles is that an auditor
cannot audit his or her own work. The
Committee considered whether the
current auditor independence rules
should be modified for smaller public
companies to make it clear that an
auditor may provide some assistance.
In May 2005, the Commission issued
a statement related to internal control
reporting requirements that also
discussed this issue.209 The
Commission stated that as long as
management makes the final
determination regarding the accounting
to be used for a transaction and does not
rely on the auditor to design or
implement internal controls related to
that accounting, it did not believe that
the auditor’s providing advice or
assistance, in itself, constitutes a
violation of the independence rules. The
Committee considered whether this
guidance would enable an auditor to
provide assistance to smaller public
company related to new and/or
complicated accounting standards or
with unusual/complicated transactions.
Ultimately, we concluded that no
modification to the Commission’s
independence rules is warranted with
respect to auditors providing assistance
to smaller public companies. In making
this recommendation, we noted the
principle that auditors should not audit
their own work and believe this basic
premise is critical to ensuring auditor
independence and the resulting
confidence of investors in the financial
statements of all companies, including
smaller public companies. The
Committee concluded that a separate set
of auditor independence rules for larger
and smaller publicly-held companies
would be inappropriate. We believe that
our recommendation to apply the same
extended effective dates for microcap
companies that the FASB provides for
private companies will help serve to
alleviate the pressure and costs to
microcap companies in implementing
new accounting standards and reduce
Developments (‘‘Bailey 2005 AICPA Remarks’’)
(discussing principles regarding auditor
independence).
208 See Preliminary Note to Rule 2–01 of
Regulation S–X and Item 201(c)(4) of Regulation S–
X, 17 CFR 210.2–01(c)(4); Exchange Act Section
10A(g).
209 See Commission Statement on
Implementation of Internal Control Reporting
Requirements, May 16, 2005.
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their need for significant assistance from
their auditors.
As a separate matter, we
acknowledged that the current auditor
independence rules do not provide
relief for violations of the rules based on
materiality considerations. As a result,
we believe that a seemingly
insignificant violation of the auditor
independence rules could have
significant consequences.210 These
consequences could require a company
to immediately change audit firms, to
declare its previous filings invalid and
to engage an audit firm to re-audit its
prior financial statements, creating
significant cost and disruption to the
company and its stockholders. The
Committee therefore recommends that
the SEC examine its independence rules
and consider establishing a rule
provision that provides relief for certain
types of violations that are de minimis
in nature as long as these are discussed
with and approved by the company’s
audit committee.211
Accounting Standards—Secondary
Recommendations
In addition to the foregoing primary
accounting standards recommendations,
we also submit for the Commission’s
consideration the following secondary
recommendations:
Recommendation V.S.1
Together with the PCAOB and the
FASB, promote competition and reduce
the perception of the lack of choice in
selecting audit firms by using their
influence to include non-Big Four firms
in committees, public forums, and other
venues that would increase the
awareness of these firms in the
marketplace.
This recommendation represents our
best attempt to deal with the very
serious problem of the lack of
competition in the auditing industry,
stemming in large part from market
concentration. Smaller companies are
seriously harmed by this state of
210 One witness testified that audit firms are
somewhat paranoid about violating these
independent rules and rightfully so. The SEC and
PCAOB need to go further to provide very clear
guidelines for audit firms as to what they can do
and cannot do. In order to facilitate audit firms
assist smaller public companies with their SEC
reporting, some degree of proportionality in
limiting the amount of the penalty for an
inadvertent violation of the auditor independence
rules should be used. Record of Proceedings 14
(Aug. 9, 2005) (testimony of Mark Schroeder, Chief
Executive Officer, German American Bancorp).
211 See Bailey 2005 AICPA Remarks (discussing
some of the information considered by the SEC
Office of the Chief Accountant when making
assessments regarding the impact of an
independence rules violation).
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affairs.212 A large concentration of both
large and small public companies is
audited by the Big Four audit firms.213
Notwithstanding that the Big Four audit
firms have earned a well-deserved
reputation of expertise in auditing
public companies, we heard testimony
from several non-Big Four audit firms
that indicated that they too are capable
of serving smaller public companies.214
212 One witness testified that smaller public
companies are having trouble timely filing their
annual and quarterly reports with the SEC, because
the Big Four audit firms are dropping them as
clients, generally because they fall outside the Big
Four’s profiles for acceptable risk. Record of
Proceedings 12 (June 17, 2006) (testimony of
Edward S. Knight, Executive Vice President and
General Counsel, NASDAQ Stock Market, Inc.).
Another witness testified that, due to changes in the
accounting industry resulting from the SarbanesOxley Act and consequent pressure from
institutional and retail investors, increasing
importance has been placed on using a Big Four
firm. As a result, smaller public companies, who are
the least prepared to negotiate, are increasingly
facing oligopolies, resulting in a disruption in the
normally balanced relationship between a company
and its accounting firm. Young smaller public
companies are now in constant fear that their
auditors will either increase their audit fees or
abandon them because of the pressure on the
auditing firm to obtain more profitable business
from larger companies. He recommended that
emphasis be placed on the acceptability of more
regional accounting firms for use by smaller public
companies, as well as the establishment or
encouragement of a fifth or sixth Big Four audit
firm to restore a more appropriate balance between
accounting firms and their client companies in
order to contain costs and at the same time provide
an alternative audit firm that is generally accepted
by the investment community. Record of
Proceedings 32–33, 37–38 (June 17, 2005)
(testimony of Alan Patricof, Co-Founder, Apax
Partners). See also Remarks by Christopher Cox,
Chairman, U.S. Securities and Exchange
Commission, Before the 2005 AICPA National
Conference on Current SEC and PCAOB
Developments (Dec. 5, 2005) (stating that
competition is essential for the proper functioning
of any market, and a broader and more competitive
market for audit services should be encouraged).
213 See United States General Accounting Office,
Report to the Senate Committee on Banking,
Housing, and Urban Affairs and the House
Committee on Financial Services, Public
Accounting Firms, Mandated Study on
Consolidation and Competition (GAO–03–864)
(July 2003).
214 Record of Proceedings 19 (Sept. 19, 2005)
(testimony of Richard Ueltschy, Executive, Crowe
Chizek and Company, LLC) (‘‘[S]maller public
companies, virtually all of them could be served
adequately by more than the Big Four, certainly the
eight largest firms that are subject to annual review
by the PCAOB. And, in fact, many of those smaller
public companies could also be effectively served
by the dozens of qualified regional C.P.A. firms.’’);
Record of Proceedings 129, 130–133 (Aug. 9, 2005)
(testimony of Bill Travis, Managing Partner,
McGladrey & Pullen LLP, commenting that his firm,
as well as many other second-tier non-Big Four
audit firms, have a level of expertise and resource
capabilities that can certainly serve the needs of
very large mid-market companies with global
facilities around the world, as well as a much
greater percentage of small and mid-size publiclytraded companies). See also Record of Proceedings
92 (Oct. 14, 2005) (testimony of Gerald I. White,
Grace & White, Inc., New York, New York) (‘‘I don’t
see any evidence that the large firms do any better
job than the small ones.’’).
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The PCAOB has registered and oversees
over 900 U.S. public audit firms. The
experience of some of our members, as
well as submissions made to us,
confirms a trend for smaller public
companies to consider options other
than the Big Four audit firms.215 More
encouragement should be given to audit
committees and underwriters to
seriously consider engaging a non-Big
Four audit firm. We believe that market
forces ultimately will determine which
firms will audit public companies. We
recognize the Commission’s, the
PCAOB’s and the FASB’s limited
authority to affect concentration in the
auditing industry. We also recognize
that some of our recommendations
concerning internal control may
increase the concentration of smaller
public companies with revenues over
$250 million who are audited by the Big
Four.216
215 One witness testified that, although the bottom
line is whether audit committees and investment
banks are willing to advise choosing a non-Big Four
firm, current market conditions are fortunately
driving some changes in the industry out of
necessity. Big Four firms have limited resources
and are allocating their resources to wherever the
best use of those resources may be used by their
major clients. Non-Big Four firms are benefiting
from this market development in that very high
quality public companies have to go find other nonBig Four firms to do their audits. Accordingly, he
indicated that firms like his are receiving many
inquiries as to whether they are capable of doing
the work, and are in fact winning the work,
including such firms as Grant Thornton, LLP and
BDO Seidman, LLP. Accordingly, he believes that
market conditions are doing a lot more to win work
for the non-Big Four audit firms than any marketing
communications could have done. See Record of
Proceedings 130–131 (Aug. 9, 2005) (testimony of
Bill Travis, Managing Partner, McGladrey & Pullen
LLP). See also Record of Proceedings 19 (Sept. 19,
2005) (testimony of Richard Ueltschy, Executive,
Crowe Chizek and Company, LLC) (‘‘We are seeing
today many companies at * * * the smaller end of
the large company classification, as this group’s
defined it, that are now choosing to look outside the
Big Four for their audit services. And they’re doing
so largely because of an attempt to introduce a bit
of market competition into the pricing for the
service. * * * [T]here’s a fair amount of activity in
terms of auditor change, there’s real price
competition being introduced into that process.’’);
Record of Proceedings 92 (Oct. 14, 2005) (testimony
of Gerald I. White, Grace & White, Inc., New York,
New York) (‘‘[S]maller firms seem to be clearly
gravitating away from the largest auditors to smaller
auditors. And I suspect that not just audit costs, but
404 costs are driving that process.’’).
216 See Letter from Crowe Chizek and Company
LLC to Committee (Feb. 20, 2006), available at
https://www.sec.gov/rules/other/265–23/
mhildebrand022006.pdf (‘‘Removing the auditor
involvement requirement for Smallcap companies
will cause firms other than the Big Four to have
very few internal control audit clients * * * This
will create a large, unintended competitive
advantage to the Big Four and foster further
consolidation in the audit profession.’’) and Letter
from McGladrey and Pullen LLP to Committee (Feb.
21, 2006), available at https://www.sec.gov/rules/
other/265–23/btravis022106.pdf (supporting the
efforts of the Advisory Committee but expressing
concern that the Committee’s Section 404
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We nevertheless believe that efforts to
promote competition in the auditing
industry and educate registrants in the
choice of selecting audit firms is
essential to maintain pricing discipline
and to address the perceived lack of
competition in the auditing industry.
We are therefore recommending that the
SEC, the PCAOB promote competition
among audit firms and that the FASB
further this effort by ensuring that nonBig Four firms are included in
committees, public forums, and other
venues that would increase the
awareness of these firms in the
marketplace.217
Recommendation V.S.2
Formally encourage the FASB to
continue to pursue objectives-based
accounting standards.218 In addition,
simplicity and the ease of application
should be important considerations
when new accounting standards are
established.
This recommendation is an attempt to
deal with the issue of excessive
complexity in accounting standards.219
recommendations will further concentrate audit
services of public companies with the Big 4 audit
firms and suggesting that the SEC take further
measures to ensure that there is no further audit
concentration of audit services in the United
States).
217 See, e.g., Record of Proceedings 84 (June 17,
2005) (testimony of Wayne A. Kolins, National
Director of Assurance and Chairman of the Board,
BDO Seidman, LLP, encouraging the use of
symposiums, whereby the CEO’s and CFO’s of
smaller public companies meet to discuss their
experiences using non-Big Four audit firms); Record
of Proceedings 130 (Aug. 9, 2005) (testimony of Bill
Travis, Managing Partner, McGladrey & Pullen LLP,
encouraging non-Big Four audit firms to become
more active with regulatory organizations like the
PCAOB and SEC and others to build awareness of
the capabilities of the non-Big Four audit firms);
Record of Proceedings 63–64, 82–83 (June 17, 2005)
(testimony of Alan Patricof, Co-Founder, Apax
Partners, recommending that regulatory bodies use
the bully pulpit and moral suasion to increase
awareness and acceptance of the good quality of
regional non-Big Four auditing firms, including
encouraging investment banking firms to rely upon
these non-Big Four firms).
218 See SEC Staff’s Study Pursuant to Section
108(d) of the Sarbanes-Oxley Act of 2002 on the
Adoption by the United States Financial Reporting
System of a Principles-Based Accounting System,
released in July 2003 (‘‘Principles-Based
Accounting System Staff Study’’) (‘‘objectivesoriented’’ standards are distinguished from
‘‘principles-based’’ or ‘‘rules-based’’ standards).
219 See Remarks by Robert H. Herz, Chairman,
Financial Accounting Standards Board, Before the
2005 AICPA National Conference on Current SEC
and PCAOB Developments (Dec. 6,
2005)(discussing the complexity in financial
reporting). See also Remarks by Christopher Cox,
Chairman, U.S. Securities and Exchange
Commission, Before the 2005 AICPA National
Conference on Current SEC and PCAOB
Developments (Dec. 5, 2005); Remarks by Scott A.
Taub, Acting Chief Accountant, U.S. Securities and
Exchange Commission, Before the 2005 AICPA
National Conference on Current SEC and PCAOB
Developments (Dec. 5, 2005).
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This complexity disproportionately
impacts smaller public companies due
to their lack of resources. Complexity is
created because of:
• An unfriendly legal and
enforcement environment that
diminishes the use and acceptance of
professional judgment in today’s
financial reporting system because of
fears of second-guessing by regulators
and the plaintiff’s bar.220
• Development of complex business
arrangements and accounting-motivated
transactions.221
• Constituent concerns about
earnings volatility and desire for
industry-specific guidance and
exceptions.222
• Frequent requests by preparers and
auditors for detailed accounting
guidance to limit potential
inconsistencies in the application of
accounting standards and secondguessing by the legal community and
enforcement authorities.223
Certain accounting standards create
complexity because:
220 One witness encouraged a move towards more
of a principles-based and a judgment-based
approach to accounting so that competent people
on the audit committees, in management and in the
audit firms can work together to use their respective
intellect, judgment and knowledge of the business
to determine where best to spend their time each
year, in such areas, for example, as internal control
compliance with Section 404 of the Sarbanes-Oxley
Act. He commented that all the guidance provided
so far by the SEC and the PCAOB on the use of
professional judgment is tempered, however, by the
current uncertainty as to what will be the
expectations of company management, the audit
committee and the auditor once there is a major
failure due to an unintended mistake reported in
the system. Until we see the results of such a
mistake, he believes there will continue to be
conservatism in the practice of audit firms,
management teams and audit committees. Record of
Proceedings 117–118 (Aug. 9, 2005) (testimony of
Bill Travis, Managing Partner, McGladrey & Pullen
LLP).
221 The SEC Staff’s report entitled Report and
Recommendations Pursuant to Section 401(c) of the
Sarbanes-Oxley Act of 2002 On Arrangements with
Off-Balance Sheet Implications, Special Purpose
Entities, and Transparency of Filings by Issuers
(‘‘Off-Balance Sheet Staff Study’’), released in June
2005, refers to an accounting-motivated structured
transaction as a transaction structured in an attempt
to achieve reporting results that are not consistent
with the economics of the transaction. As an
example, the report cites to the restructuring of
lease arrangements to avoid the recognition of
liabilities on the balance sheet following the
issuance of the FASB’s Statement No. 13,
Accounting for Leases, released in 1976.
222 See Principles-Based Accounting System Staff
Study (listing three of the more commonly-accepted
shortcomings of rules-based standards, such as
numerous bright-line tests, exceptions to principles
underlying the accounting standards, and
complexity in and uncertainty about the application
of a standard reflected in the demand for detailed
implementation guidance).
223 Id. See also FASB Staff Position No. 123(R)–
2, Practical Accommodation to the Application of
Grant Date as Defined in FASB Statement No.
123(R) (Oct. 18, 2005).
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• The lack of a fully developed
conceptual framework leads to
inconsistent concepts and principles
being applied across accounting
standards.224
• Scopes in standards are at times
unclear and may contain exceptions.225
• The standards have different
measurement attributes (such as
historical cost versus fair value) and
treatment alternatives.226
• Rules and bright-line standards
provide opportunities for accountingmotivated transactions that are not
necessarily driven by economics.227
• The standards themselves have
become extremely lengthy and difficult
to read.228
Additional complexity in accounting
standards also comes about because:
• In prior years, multiple parties set
standards, such as the SEC, the FASB,
the AICPA, the Accounting Principles
Board (APB), and the Emerging Issues
Task Force (EITF).
• Differing views exist on the
application of fair value measurement
techniques and models.229
• Phased projects produce only
interim changes.230
We believe that the current financial
reporting environment could be
modified to reduce the reporting burden
224 For example, related to the accounting for
revenue transactions, FASB Statement of Concepts
No. 5, Recognition and Measurement in Financial
Statements of Business Enterprises, states that
revenues are not recognized until earned. FASB
Statement of Concepts No. 6, Elements of Financial
Statements, defines revenues as inflows or other
enhancements of assets or liabilities. The FASB
currently has a revenue recognition project on its
agenda designed in part to eliminate this
inconsistency. The FASB also has on its agenda a
joint project with the International Accounting
Standards Board to develop a common conceptual
framework that is complete and internally
consistent.
225 For example, FASB Interpretation No. 45,
Guarantor’s Accounting and Disclosure
Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others, clarifies the
scope of FASB Statement No. 5, Accounting for
Contingencies. This interpretation excludes certain
guarantees from its scope and also excludes other
guarantees from the initial recognition and
measurement provisions of the interpretation.
226 See, e.g., FASB Statement No. 115, Accounting
for Certain Investments in Debt and Equity
Securities (providing classification alternatives for
investments in debt and equity securities, resulting
in different measurement alternatives).
227 See Off-Balance Sheet Staff Study.
228 See, e.g., FASB Statement No. 133, Accounting
for Derivative Instruments and Hedging Activities
(June 1998) (exceeding 800 pages of authoritative
guidance and over 180 implementation and
interpretive issues).
229 The FASB currently has a project on its
agenda to provide guidance regarding the
application of the fair value measurement objective
in generally accepted accounting principles.
230 For example, FASB Statement No. 150 is part
of the FASB’s broad project on financial
instruments that was added to the FASB’s agenda
in 1986.
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on smaller public companies, as well as
larger public companies, while
improving the quality of financial
reporting.
We commend the efforts of the SEC
and FASB to pursue ‘‘objectives-based
accounting standards,’’ as this should
help to reduce complexity.231 The
Committee recognizes that success will
require preparers, financial advisors and
auditors to apply the intent of the rules
to specific transactions rather than using
‘‘bright-line’’ interpretations to achieve
a more desirable accounting treatment.
The Committee also believes that
simplicity and the ease of application of
accounting standards should be
important considerations when new,
conceptually-sound accounting
standards are established. Success will
also require regulators and the courts to
accept good faith judgments in the
application of objectives-based
accounting standards. We believe these
goals will only be accomplished by
long-term changes in culture versus
short-term changes in regulations. This
will allow for greater consistency and
comparability between financial
statements.
Accordingly, we offer the following
suggestions aimed at simplifying future
accounting standards:
• There should be fewer (or no)
exceptions for special interests.
• Industry and other considerations
that do not necessarily apply to a broad
array of companies should be addressed
by FASB staff positions rather than in
FASB statements.
• FASB statements should attempt to
reduce or eliminate ‘‘bright-line tests’’
in accounting standards, and in cases
where the standard-setter intends that a
‘‘bright-line’’ test be applied make that
clear in the guidance.
The Committee is making this
recommendation in lieu of
recommending modifications to certain
existing accounting standards for
smaller public companies. Primarily
through our Accounting Standards
Subcommittee, we identified certain
accounting standards where
modifications might be considered in
the future for smaller public companies.
The Committee recognized that smaller
public companies, as well as larger
public companies, struggle with the
application of certain accounting
standards, such as FASB Interpretation
No. 46 (revised December 2003),
Consolidation of Variable Interest
Entities. The Committee also looked for
231 See, e.g., SEC Staff Study, The PrinciplesBased Accounting System. See also FASB Response
to SEC Study on the Adoption of a Principles-Based
Accounting System (June 2004).
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certain common themes in those
standards that could be used to develop
recommendations regarding accounting
pronouncements.
In reviewing existing accounting
standards, we considered the effect of
their measurement and disclosure
requirements on smaller public
companies. The Committee also
considered possible screening criteria
that could be used to determine whether
an accounting standard should be
modified for smaller public companies.
The objective of our efforts was to
determine whether for certain
accounting standards, the information is
very costly for a small business to
prepare and yet the information is not
being utilized by its investors or other
users of its financial statements.
After deliberating these questions, we
unanimously concluded that, since we
believe it is inappropriate to create
different standards of accounting for
smaller public companies (i.e., Big
GAAP versus Little GAAP), we should
not propose recommendations to modify
existing accounting standards for
smaller public companies.
In sum, we agreed that the current
financial reporting environment could
be improved to reduce the reporting
burden on both smaller public
companies, as well as for larger public
companies, while improving the quality
of financial reporting. In this light, we
formulated the above recommendation
to have the SEC formally encourage the
FASB to continue to pursue objectivesbased accounting standards. The
Committee also recommended that
simplicity and the ease of application
should be key considerations when
establishing new conceptually-sound
accounting standards.
Recommendation V.S.3
Require the PCAOB to consider
minimum annual continuing
professional education requirements
covering topics specific to SEC matters
for firms that wish to practice before the
SEC.
Of the 939 U.S. audit firms registered
with the PCAOB, we noted that
approximately 82% of them audit five
or fewer public companies. We believe
that continuing professional education
pertaining to SEC-related topics would
be useful to the professional personnel
of registered firms, especially for those
firms that do not audit many public
companies and for which this training
would improve their ability to serve
public companies. While several
different groups and governmental
bodies, such as the individual state
licensing boards, establish continuing
professional education requirements for
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accountants, the PCAOB does not
currently have any minimum annual
training standards for registered firms’
partners and employees who serve
public companies. The Committee
suggests, therefore, that minimum
annual SEC training requirements be
established for applicable partners and
employees of audit firms registered with
the PCAOB.
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Recommendation V.S.4
Monitor the state of interactions
between auditors and their clients in
evaluating internal controls over
financial reporting and take further
action to improve the situation if
warranted.
The recent implementation of
Sarbanes-Oxley Act Section 404 by
certain public companies has raised
many questions and issues. One issue
that has been identified pertains to the
adverse impact Section 404 has had on
the relationship between audit firms
and the management of smaller public
companies and the nature and extent of
their communications on accounting
and financial reporting matters.232 We
noted the substantial amount of
testimony on this issue.233 We also
232 The SEC Staff’s Statement on Management’s
Report on Internal Control Over Financial
Reporting, released in May 2005, stated that
feedback from both auditors and registrants
revealed that one potential unintended
consequence of implementing Section 404 and
Auditing Standard No. 2, An Audit of Internal
Control Over Financial Reporting Performed in
Conjunction with An Audit of Financial Statements,
has been a chilling effect in the level and extent of
communications between auditors and management
regarding accounting and financial reporting issues.
233 One witness commented that audit firms are
too fearful to provide guidance and advice to any
inquiry by a public client, as such inquiry could be
interpreted as an admission of an internal control
weakness by the company in that area. Although he
recognizes that auditing firms cannot provide nonaudit services to their clients, he believes that they
should be able to point their clients in the right
direction so that the client can do the work. He
indicated that audit firms are unclear as to where
the line of auditor independence is drawn. As a
result, when in doubt, audit firms take the safe
route and do nothing out of fear that if they cross
the line, they will put the entire audit firm at risk.
Record of Proceedings 24 (Aug. 9, 2005) (testimony
of Mark Schroeder, Chief Executive Officer, German
American Bancorp.). Similarly, another witness
testified that auditors and audit committees are too
fearful of lawsuits to rely upon their judgment in
implementing Section 404 internal controls. He
believes explicit common sense standards applied
universally to all companies of a given size need
to be developed by the regulators to indicate clearly
what the auditors need to cover, and what the
materiality levels are. Record of Proceedings 189
(Aug. 9, 2005) (testimony of James P. Hickey,
Principal, Co-Head of Technology Group, William
Blair & Co.). See also Record of Proceedings 126–
127, 139 (August 9, 2005) (testimony of Bill Travis,
Managing Partner, McGladrey & Pullen LLP,
commenting that once there is greater consistency
and clarification on what is expected by the PCAOB
and its inspectors with regard to Auditing Standard
No. 2, the time, effort and costs incurred by the
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noted that the PCAOB and the SEC had
issued guidance in May 2005 regarding
auditors will be reduced and the willingness of
auditors to use their professional judgment will
increase); Record of Proceedings 9–18, 56 (Oct. 14,
2005) (testimony of Thomas A. Russo, Russo &
Gardner, Lancaster, Penn., describing a very stark
tension growing between companies and their
auditors, due to the lack of PCAOB Section 404
guidelines which has resulted in a zero percent sort
of materiality test as auditors are unwilling to
exercise judgment, but rather go to the end of the
earth to confirm the integrity of control systems);
Record of Proceedings 57, 61 (Sept. 19, 2005)
(testimony of Kenneth Hahn, Senior Vice President,
Chief Financial Officer, Borland Software Corp.,
Cupertino, Calif., commenting that the dynamics of
risk make it virtually impossible for the control
portion of Section 404 to be cost effective for small
and mid-size companies, as both auditors and
boards will make the decision to over-engineer the
testing of a company’s internal control systems);
Record of Proceedings 100 (June 17, 2005)
(testimony of Prof. William J. Carney, Emory
University School of Law, referring to a study
indicating that auditing fees have increased by as
much as 58%, due to the increased costs associated
with the new requirements of the Sarbanes-Oxley
Act). But see Record of Proceedings 33–34 and 41
(Sept. 19, 2005) (testimony of Lynn E. Turner,
Managing Director of Research, Glass Lewis & Co.,
predicting the costs of Section 404 internal controls
to come down after the first year of implementation,
and commenting that both in-house accountants
and external auditors are working together to make
the implementation of Section 404 internal controls
for smaller companies much more difficult than
warranted); Record of Proceedings 18–19 (Sept. 19,
2005) (testimony of Richard Ueltschy, Executive,
Crowe Chizek and Company, LLC, anticipating
costs to implement Section 404 internal controls for
the second year to fall, and noting that auditors are
now willing to provide fixed fee quotes both for
smaller public companies in their second year of
404 implementation, as well as for new accelerated
filers undertaking their fist year of 404
implementation); Record of Proceedings 106 (Sept.
19, 2005) (testimony of Michael McConnell,
Managing Director, Shamrock Capital Advisors,
Burbank, Calif., indicating that most investors,
including both direct investors and institutional
capital, do not have a problem with the costs of
Section 404, as opposed to the capital raising
agency community, such as the lawyers, bankers
and managers, that are uncomfortable in general
with any heightened standards of accountability).
One witness testified that several public equity
offerings in which he was involved experienced
unprecedented delays due to the inability or
unwillingness of the auditors to provide timely
responses during the registration process with the
SEC. He believes that auditors can no longer be
looked to for advice on how to handle various
issues, as it seems that almost every issue now
needs to be ‘‘run through the national office’’ of the
auditor. He notes that as auditor responses may
now take weeks longer to be produced than was the
case a couple of years ago, he believes such delays
leave potential issuers subject to additional market
risk that did not exist in the past. Record of
Proceedings 176 (Aug. 9, 2005) (testimony of James
P. Hickey, Principal, Co-Head of Technology Group,
William Blair & Company). See also Record of
Proceedings 33 (June 17, 2005) (testimony of Alan
Patricof, Co-Founder, Apax Partners, explaining
that an unnatural relationship has developed
between companies and their auditors as
accountants have become more gun shy about
taking a risk-focused approach to their audit and
express concerns about the pressure to comply with
PCAOB requirements which has caused the
relationship between auditors and companies to go
from one of cooperation and consultation to that of
an adversarial nature).
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the implementation of Section 404 and
the interaction between an auditor and
its client.234
It appears that audit firms are starting
to become more comfortable with the
idea that it is acceptable to advise their
clients with respect to new accounting
standards and/or complicated
transactions, consistent with the
guidance issued by the PCAOB and
SEC, while remaining fully cognizant of
the need for company management to
take full responsibility for its financial
statements and the underlying decisions
on the application of accounting
principles. We recommend that the SEC
and the PCAOB remain vigilant in
monitoring the impact of its guidance
through the Spring of 2006 reporting
season. If the guidance is being
appropriately applied, no further action
with respect to the interaction of the
auditor and its clients would be
required, except for implementation of
our recommendation on implementing a
de minimis exception for certain
immaterial violations of the SEC’s
independence rules.
Part VI. Epilogue
[Content of Part VI To Be Included in
Final Report.]
Part VII. Separate Statement of Mr.
Jensen
Introduction
I am dissenting to recommendations
III.P.1, III.P.2 and III.P.3 contained in
the Final Report of the Advisory
Committee. Since the time of the
original vote on the recommendations, I
have become aware that certain investor
groups are concerned with the removal
of Section 404 of the Sarbanes-Oxley
Act of 2002 requirements for a large
number of public companies. While no
one knows the exact extent of investor
opposition, I believe this group is too
important to the health of our capital
markets to ignore their point of view.
Specifically, I believe that providing a
permanent exemption for smaller public
companies from these requirements may
ultimately harm investors of those
companies. In addition, I disagree with
the adoption of a weakened auditing
standard for Section 404 compliance by
certain companies.
The fact that the Advisory Committee
heard so many different points of view
on these critical issues supports the fact
that we do not yet have sufficient
experience with implementation of
Section 404 to know with certainty that
a permanent exemption is a better
234 See SEC Statement on Implementation of
Internal Control Reporting Requirements, May 16,
2005.
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answer, or whether any change in
auditing standards is warranted. In light
of these factors, my recommendation
calls for additional temporary deferrals
coupled with a study of key
implementation elements and a
definitive timetable for resolution.
Dissenting Views and Rationale
I agree with the rationale in the Final
Report describing the need to scale
securities regulation for smaller
companies. As a member of the
Advisory Committee I heard testimony
from many on the potentially damaging
impact of the costs of Section 404 on the
growth potential of smaller public
companies. Additionally, many parties
provided written comment on the
disproportionate burden of Section 404
related costs on smaller public
companies. The Final Report includes a
number of examples and anecdotes on
the reasons for this disproportionate
burden including constraints caused by
limited internal and external resources,
lack of guidance tailored to smaller
companies and less revenue with which
to offset implementation and ongoing
compliance costs. I acknowledge that
this cost issue necessitates a significant
and substantial effort to develop an
appropriate application of Auditing
Standard No. 2 in the small public
company environment.
I am also cognizant of testimony and
written comments the Committee
received on the significant benefits of
Section 404. Many reminded the
Advisory Committee of the corporate
failures that resulted in Congress
enacting the Sarbanes-Oxley Act of
2002. Other investors gave testimony on
the benefits of Section 404 both to
themselves and to the companies in
which they invest and the increased
confidence instilled in the investor
community as a result of the additional
checks and balances required by the
Act. A smaller public company, as
information provided to the Advisory
Committee indicates, is more likely to
suffer control deficiencies than a larger
company. This fact logically means that
investors will consider their investment
in smaller public companies a higher
risk. It seems, therefore, that smaller
public companies could benefit from a
process that improves investor
confidence in their financial reporting
thereby helping them achieve a wider
and more diverse investor base. If such
benefits for both companies and
investors can be derived from Section
404, then it seems to me that
eliminating the requirement for these
companies is unwarranted. Rather, more
effort should be expended to scale the
approach to smaller public companies.
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The key is to balance the needs of the
users of financial statements with the
costs to companies in supplying the
required information. Balancing what
preparers of financial statements can
reasonably provide and what users of
financial statements can reasonably
expect to receive is a basic principle of
our financial reporting and regulatory
systems. The current debate around
Section 404 demonstrates clearly that
this required balance does not exist at
smaller public companies today. Many
smaller public companies have
indicated that the solution to this
problem is to eliminate their
compliance with Section 404. However,
simply eliminating the requirement will
tip the scales and investors, who will
not receive the information and
assurances intended to be provided
under the Act, will likely believe that
the system is out of balance to their
detriment. I believe that through
additional implementation experience,
guidance and tools, Section 404
reporting can become more efficient and
cost-effective for smaller public
companies.
I disagree with the adoption of an
alternative auditing standard. A lesser
standard may prove not to be in the
interest of the smaller public company
as it creates a two tier system. The
existence of a two tiered system could
reduce investor confidence in the
smaller public companies’ financial
reporting process and would thereby
eliminate all of the benefits of Section
404 which, as discussed above, may be
an important benefit that could be
derived by smaller public companies. I
believe that effective Section 404
compliance in the smaller public
company will continue to improve
investor confidence and I also strongly
believe that compliance can be achieved
in a cost effective manner.
Further Consideration
Accordingly, in lieu of permanent
exemptions, I recommend an additional
temporary deferral of the Section 404
reporting for non-accelerated filers that
have not yet reported under Section
404, coupled with a definitive action
plan led by the SEC as outlined below.
This plan includes participation by
smaller public companies, the auditing
profession and the PCAOB. Given the
cost concerns provided to the Advisory
Committee on smaller public
companies, such an additional
temporary deferral could include an
optional, temporary suspension of
certain of the requirements for smaller
public companies that recently
implemented the Section 404
requirements and meet the market
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capitalization and revenue criteria in
recommendations III.P.1 and 2. On this
latter point, the SEC would have to
weigh the implications of this proposal
with the likelihood that many of the
companies already complying would
nonetheless choose to continue to
comply.
The steps that I would propose would
be subject to a defined timeline and a
set of actions to definitively resolve the
scope of Section 404 implementation for
smaller public companies prior to the
2008 year-end. For example, these
actions could include:
• Reconsideration of the end product
in the ongoing process to tailor the
COSO requirements for smaller
businesses. This project has been
underway for some time. It is essential
that the final document succeed in
being truly useful to smaller companies.
It is vitally important that the final
document be replete with guidance,
examples and tools, which permit the
efficient implementation and testing of
COSO requirements for smaller
businesses. A definitive guide for
performing management’s assessment of
internal control effectiveness for smaller
public companies would be the single
most useful element of this effort.
• The conduct of an SEC-led pilot
program for a prescribed number of
micro-cap and smaller public
companies during 2006 that would
serve as a field test and lead to the
development of guidance on application
of AS2 in that environment for auditors,
as well as the development of internal
control and Section 404 compliance
tools for management of micro-cap and
smaller public companies.
• An in-depth study of the companies
that have two years of experience in
complying with Section 404, perhaps by
focusing on the smaller of the
complying companies in order to gain
an in depth understanding of the costs
and benefits. The criticality of reliable,
not anecdotal, cost-benefit information
is a fundamental predicate to finalizing
the important regulatory and public
policy decisions that the SEC needs to
make.
The basic timeline for this action plan
could be: Pilot program and study in
2006, develop and field test guidance
and rules in 2007, and implement in
2008.
Should this recommendation be
adopted, my firm would be willing
dedicate resources to participate in any
efforts to gather evidence, field test new
guidance, or develop tools for
management and auditors that will
further support this process. We would
look forward to working with others in
the accounting profession, vendors of
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technology solutions, and companies in
the program and other public and
private-sector organizations to achieve
success in this endeavor.
It is important to note that this
timeline includes only one additional
annual deferral of the Section 404
requirements for non-accelerated filers;
however, it should also include specific,
defined steps during this period, to
significantly improve guidance and
tools, and increase the cost effectiveness
of implementation for smaller public
companies.
This recommendation is made with
our mutual public interest goals in
mind. It reflects my opinion that after
only two years of implementation for
accelerated filers, market participants
and regulators do not have sufficient
information to make final decisions
regarding the long-term application of
these important internal control
requirements for smaller public
companies. I recommend that a process
be developed to gather empirical, fielddriven information to resolve this
important question, and that an
additional deferral be granted until this
can be accomplished.
Part VIII. Separate Statement of Mr.
Schacht
This Separate Statement to the Final
Report of The Advisory Committee on
Smaller Public Companies (the
‘‘Report’’) is submitted for the purpose
of dissenting on several of the primary
recommendations of the Advisory
Committee. These relate to the work of
the sub-committee on Internal Controls
Over Financial Reporting (the ‘‘SubCommittee’’). As a member of the SubCommittee and consistent with our
dissenting opinion of December 14,
2005, a copy of which is attached, we
remain opposed to key portions of the
Report.
Observers and committee participants
agree that the most substantive
recommendations in the Report relate to
the application of Section 404 of
Sarbanes-Oxley (‘‘Section 404’’) to
smaller public companies. As a
Committee, we reviewed several issues
impacting smaller public companies. It
is clear however, that the impacts of
Section 404, particularly the resource
demands and costs of implementing
404, have proven to be the most
challenging. During our deliberations,
the Sub-Committee discussed dozens of
ways and options for reducing costs,
while maintaining investor protections.
Cost-Benefit Analysis
The Advisory Committee members
generally agree that the costs of
Sarbanes- Oxley (‘‘SOX’’) are the real
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issue. While minimization of regulatory
costs is always a desirable goal, the
Report confirms what we knew coming
into this Committee process, that the
costs have exceeded all estimates, and
have significantly impacted small
companies. There have been numerous
cost studies and other anecdotal
comments on whether these costs are, or
will be, coming down in subsequent
years. The evidence will only be clear
once we have actual data in the coming
months. For many companies that have
yet to go through the process, the initial
costs will be high. But the analysis must
not end there. It suggests that whatever
the benefits of Section 404 might be,
they are surely far outweighed by these
more obvious cost figures. The Report
states that the benefits are of less certain
value and moves on to other matters.
The Advisory Committee, by and
large, agrees that internal controls over
financial reporting at public companies
are important. More specifically, we
assert they are an important feature for
accurate financial reporting, investor
protection, and market integrity. But is
there a measurable benefit? It is
impossible to measure the value of a
financial/accounting fraud avoided. In
2005, there were approximately 1300
restatements and weaknesses in
financial reporting revealed and fixed
by a Section 404 inspired process, more
than double the number in 2004. This
dramatic increase will have an
inestimable and far-reaching impact on
financial reporting reform. Some argue
this is a reflection of deferred
maintenance on an internal controls
process that has been neglected and that
SOX represents a renaissance for proper
internal control process and
environments. Whatever the reason,
these are benefits that are significant
and certain. Moreover, they are benefits
which, we believe, balance the cost of
a properly scaled and verified internal
control structure.
Section 404 Exemption vs. Improved
Section 404 Implementation
The Sub-Committee set about its work
with the focus of adjusting the main cost
driver of Section 404, the level to which
internal controls need to be
documented, verified and tested by
management and outside auditors. The
original objectives were to reduce the
cost burdens but maintain the investor
protections associated with Section 404.
The Sub-Committee focused on a variety
of ways to meet the objectives but
narrowed its attention to two. The first
is creating a more tailored and costefficient internal control structure and
verification process for small
companies, i.e., reducing the cost and
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resource drain of Section 404 through
better implementation. The second is
providing small companies with an
exemption from the main requirements
of Section 404.
The objectives of cost control and
investor protection need not be
mutually exclusive. However, the
Report’s primary recommendations
make them so. Our strongest objection is
that the Report recommends a flat-out
exemption from all auditor 404
involvement in reviewing and
confirming internal controls. This is not
for just a few, but for what will
effectively be more than 70 to 80
percent of the public companies in this
country.
One could cite any number of flaws
in this approach, but several in
particular stand out:
• First, the entire premise of SOX was
to bolster investor confidence by
requiring meaningful corporate
governance and financial reporting
reforms. Likewise, maintaining investor
protections is a primary tenet of the
Committee Charter. Properly designed
and functioning internal controls over
financial reporting were and are a
cornerstone of this legislation. Proper
structuring and implementation of 404
requirements are very different from
eliminating these completely for a broad
segment of U.S. companies. That
approach works against the statute’s
legislative intent and the directive that
we heard from both Chairman
Donaldson and Chairman Cox.
• Second, it is unclear to many
whether the broad exempting
recommendations of this subcommittee
are even within the commission’s legal
authority. Comprehensive, sweeping
exemptions from Section 404 may not
be possible under the current
legislation, which specifically excluded
Section 404 from the Securities and
Exchange Act of 1934. As the full
Commission works toward final
recommendations, it would be well
served to resolve that potential legal
uncertainty so as to avoid further
litigation delays in addressing Section
404 concerns.
• Third, with regard to MicroCaps as
defined, the Report recommends
exemptive relief from not only auditor
involvement in reviewing internal
controls but also exempts the managers
of these firms from having to do their
own internal assessment of such
controls. Essentially, no one has to
check the design, implementation and
effectiveness of internal controls over
financial reporting at these companies.
The reason for this complete 404
exemption according to the Report is
that there is no specific directions/
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guidance available to such small
company managers to know how to
create an appropriate internal control
structure. We wonder about two things
in this context. First, how have these
firms been able to meet the on going
legal requirements for maintaining an
effective system of internal controls
(actually mentioned as part of the
recommendation) and more
importantly, if such guidance is missing
for micro caps, how does it suddenly
become clear for managers of small
companies above $125 million in
market cap? In the event any of these
exemptive recommendations are
adopted by the SEC, we believe logic
dictates that managers in all public
firms be required to complete an annual
Section 404 assessment of internal
controls.
• Fourth and maybe most important,
small public companies need checks
and balances over financial reporting.
This includes the Section 404 checks
and balances in our view. The Report
indicates that: Small cap firms have less
need for internal controls; requiring
external verification of internal controls
is a waste of corporate resources; and,
that better corporate governance is a
substitute for such verification. It
further suggests that investors in these
companies don’t particularly care about
internal control protections and that
these companies represent an
inconsequential bottom 6% of total U.S.
market capitalization, rendering even an
Enron-like blowup a minor event. At the
same time, the Report characterizes
such small companies as a critical link
in economic growth and
competitiveness and that Section 404 is
the regulatory tipping point and barrier
to accessing public markets. Parsing
through these contrasting views of
inconsequential vs. critical seems to
suggest incorrectly that venture capital
exit strategies are more important to
protect than public investors providing
risk capital. A number of experts we
heard from feel that properly structured
and verified internal controls are
probably more important for the riskier,
smaller firms and that additional
corporate governance provisions are in
no way a substitute for properly
working internal controls. For example,
these small firms consistently have
more misstatements and restatements of
financial information, nearly twice the
rate of large firms, according to one
report. Alarmingly, these small firms
also make up the bulk of accounting
fraud cases under review by regulators
and the courts (one study puts it at 75
percent of the cases from 1998–2003).
• Finally, we note that as part of each
of the recommendations for Section 404
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exemption, the Report suggests these
companies be reminded of pre-SOX
legal requirements to have an effective
system of internal controls in place.
This legal reminder simply points out
how ineffective the rules were pre-SOX
and how they are no substitute for
having some level of external
verification of controls as prescribed by
Section 404.
Better Implementation of Section 404 &
SOX ‘‘LIGHT’
A more balanced approach to fixing
the cost concerns of Section 404 is to
continue requiring manager assertions
and auditor attestation of internal
controls, but direct the appropriate
regulatory and de facto standard-setting
bodies (the Committee of Sponsoring
Organizations of the Treadway
Commission (COSO), the Public
Company Accounting Oversight Board)
and the SEC to develop specific
guidance for small companies. This
approach has been referred to as a ‘‘404
Light’’ or ‘‘SOX Light’’ approach.
However, the term has become
confusing over the course of the
Committee debate.
Much of the outline for this approach
appeared in preliminary
recommendations of the SubCommittee. We encourage the
Committee to be clear on the options for
better implementation and for the
Commission to consider a broad range
of approaches. These may include: (1)
Reviewing/refining the existing AS–2
standards; (2) possible development of
an alternative auditing standard (the
Report references AS–X) that provides
for a meaningful, but more cost effective
audit; and (3) development of specific
directives from COSO and PCAOB on
how to ‘‘right-size’’ for small issuers, the
control structure, the requirements for
managers assessment and the scope of
an internal controls audit.
This ‘‘Better Implementation’’
approach appears in the Report, but
comes only as a fall-back alternative to
the exemptive recommendations. To
ensure continued investor confidence in
our markets, we support the approach
that preserves the investor protection
aspects of 404 while lowering costs to
implement and verify proper internal
controls over financial reporting.
Investors Support Section 404
It is clear that we need to do
something for small companies.
Investors in these companies, more than
anyone, have a significant stake in
making sure we balance the regulatory
burden with the need to grow and
access capital markets. Investors and the
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economy are ill-served by a system that
neglects either.
We heard commentary from several
professional investors and institutional
managers in support of Section 404
requirements. The weight of such
testimony has been questioned since
many do not invest directly in micro
cap firms. Moreover, the lack of specific
individual testimony from micro cap
and small cap investors along with the
observation that people still invest in
these firms without Section 404
protections, both in U.S. and foreign
markets, has been suggested as evidence
that investors do not care about section
404 protections.
While we encourage more of these
small company investors to come
forward and participate in the next
comment period, we believe the
investor base involved in these firms is
very fragmented. These companies
represent somewhere between 70 and 80
percent of public companies and
collectively have millions of individual
retail and private shareholders. It is
unlikely this group will magically
coalesce and speak with a collective
voice on this or any other regulatory or
financial reporting issue affecting the
companies in which they invest. That
silence should not be misinterpreted.
These are precisely the investors that
need the formal and self-regulatory
‘‘system’’ to provide the necessary
protections, transparency and honesty
that ensures a fair game. It is what
continues to make U.S. markets the gold
standard.
We appreciate the opportunity to
serve on the Advisory Committee and to
serve as a representative for investor
views. We encourage investors to
provide timely commentary to this
Report. As with any regulation, it is
important to reach the proper balance
between cost burden on the issuer and
investor protection. We firmly support
realignment and better implementation,
not elimination of Section 404, as the
proper balance.
Statement of Mr. Schacht Dated
December 14, 2005
I appreciate the opportunity to
address the entire committee on the
work of the 404 subcommittee and want
to acknowledge all of my colleagues’
hard work. It was a pleasure working
with them.
As a committee, we have reviewed
several issues affecting smaller public
companies. It is clear however, that the
impacts of Section 404 of SarbanesOxley, particularly the implementation
costs, have proven to be by far the most
challenging. While I do not agree with
several subcommittee
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recommendations, Section 404 is one of
the key issues to focus on. Solutions to
its overly burdensome cost, particularly
on small issuers, are not simple.
Notwithstanding that I am the lone
dissenting vote on the subcommittee, I
do want to acknowledge that this group
has examined this topic closely. They
fully considered my concerns and those
of others who commented on the proper
ways to ‘‘fix’’ 404. We discussed dozens
of ways and options for reducing costs,
while maintaining investor protections.
We all agree that the costs of SOX are
the real issue. They have been too high,
exceeding all estimates, and they hit
small companies much more
significantly. There have been
numerous cost studies and other
anecdotal comments on whether these
costs are or will be coming down in
subsequent years. I think the evidence
will only be clear once we have actual
data in the coming months, because this
is clearly not yet at a point of
equilibrium. For many companies that
have yet to go through the process, the
initial costs will be high. There is no
question about this.
Also, we all agree that internal
controls at public companies are
important. They are an important
feature for accurate financial reporting,
investor protection, and market
integrity. Some argue that internal
controls have been somewhat neglected,
and SOX has tried to bring about some
assurance that adequate controls are in
place and working as desired. How the
markets get that assurance—that is, the
level to which these internal controls
need to be verified and tested by
management and outside auditors—is
the rub.
The subcommittee goal was to reduce
the cost burdens but maintain the
investor protections associated with
Section 404. These need not be
mutually exclusive. My concern, and
the basis for my dissent, is that the
panel’s recommendations make them
mutually exclusive. We seem to say you
can’t have meaningful cost reductions
unless you eliminate 404, including the
investor protections.
Our biggest concern is that the main
recommendations give a flat-out
exemption from all auditor 404
involvement in reviewing and
confirming internal controls. This is not
for just a few, but for what will
effectively be more than 80 percent of
the public companies in this country.
One could cite any number of flaws
in this approach, but three in particular
stand out:
• First, the entire premise of SOX was
to bolster investor confidence by
requiring meaningful corporate
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governance and financial reporting
reforms. Properly designed and
functioning internal controls over
financial reporting were and are a
cornerstone of this legislation. Proper
structuring and implementation of 404
requirements are very different from
eliminating these completely for a broad
segment of U.S. companies. That
approach works against the statute’s
legislative intent and the directive that
we heard from both Chairman
Donaldson and Chairman Cox.
• Second, it is unclear to many
whether the broad exemptive
recommendations of this subcommittee
are even within the commission’s legal
authority. Comprehensive, sweeping
exemptions from Section 404 may not
be possible under the current
legislation, which specifically excluded
Section 404 from the Securities and
Exchange Act of 1934. As the full
committee works toward final
recommendations, it would be well
served to resolve that issue, as I expect
there will be legal challenges of this
authority.
• Finally, and maybe most
importantly, small public companies
need checks and balances over financial
reporting. They consistently have more
misstatements and restatements of
financial information, nearly twice the
rate of large firms, according to one
report. Alarmingly, they also make up
the bulk of accounting fraud cases under
review by regulators and the courts (one
study puts it at 75 percent of the cases
from 1998–2003).
A more balanced approach to fixing
SOX 404 is to continue requiring
manager assertions and auditor
attestation of internal controls, but
direct the appropriate regulatory and
defacto standard-setting bodies (the
Committee of Sponsoring Organizations
of the Treadway Commission (COSO),
the Public Company Accounting
Oversight Board) and the SEC to
develop specific guidance for small
companies. These would specifically
outline appropriate control structures
and the auditing scope for small
companies under 404—a SOX ‘light’
approach.
Much of the outline for this approach
appears in Recommendation 3 of the
subcommittee’s report. However, it
comes only as a fall-back alternative to
the exemptive recommendations. To
ensure continued investor confidence in
our markets, we deserve an approach
that preserves the investor protection
aspects of 404 while lowering costs to
implement and verify proper internal
controls over financial reporting.
It is clear that we need to do
something for small companies. But
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giving them a pass on any verification
and oversight of internal controls will
come back to haunt us.
The subcommittee’s
recommendations will now attract a
fuller public debate on some very
important public policy issues. I would
offer this challenge to investors and,
indeed, all participants in the financial
reporting process to get involved in
commenting on these recommendations.
It is important to reach the proper
balance between cost and investor
protection. Realignment not elimination
of Section 404 is needed to accomplish
that.
Part IX. Separate Statement of Mr.
Veihmeyer
Section 404 of Sarbanes-Oxley has
contributed significantly to the
improvement of financial reporting,
oversight of internal controls, and audit
quality. The public interest and the
capital markets have been well served
by this legislation. At the same time,
compliance with the provisions of
Section 404 has placed important
responsibilities on issuers and auditors
that are both expensive and time
consuming. Clearly, the important goals
of Section 404 must be achieved in the
most cost-effective and least
burdensome manner, to ensure that the
costs of Section 404 do not outweigh the
benefits. This is particularly challenging
with respect to smaller public
companies. The Advisory Committee on
Smaller Public Companies has worked
very hard to determine where to strike
the appropriate balance between the
benefits to investors and the burdens on
issuers. The Final Report of the
Advisory Committee is the result of that
work. While I respect the Committee’s
efforts to find the best possible solutions
to these difficult problems, I differ with
the majority over one fundamental
principle. In my judgment, sound public
policy dictates that the protections
provided by Section 404 should be
available to investors in all public
companies, regardless of size.
Accordingly, our focus at this time
should not be on exempting companies
from Section 404, but on developing
implementation guidance for assessing
and auditing internal control over
financial reporting for smaller public
companies that recognizes the
characteristics and needs of those
companies. This guidance should be
jointly developed by regulators, issuers
and the accounting profession and
should be field-tested for effectiveness,
including appropriate cost analysis,
before implementation.
The Final Report provides extensive
root-cause analysis of the costs of
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compliance with Section 404, but fails
to address the reality that economies of
scale do influence the relative cost of
regulatory compliance and professional
services, including audits of financial
statements. Therefore, there is need for
additional steps to be taken to further
improve the execution of Section 404
compliance relative to smaller
companies, as described below.
I also believe that PCAOB Auditing
Standard No. 2 is fundamentally sound
and scalable, and it is not prudent to
consider amending the Standard at this
time. The first year of integrating the
financial statement audit with the
requirements of Auditing Standard No.
2 was a difficult process due to a
number of environmental issues that
have been well-documented. Simply
stated, the full integration of the
financial statement and internal control
audit did not occur in year one.
However, my firm’s experience is that
the additional year of experience,
coupled with the May 2005 guidance
from the SEC and the PCAOB, and the
efforts of issuers and auditors to
improve their respective approaches,
has resulted in further integration of the
financial statement and internal control
audit and is reducing the total cost of
compliance. I believe that issuers and
auditors should be allowed the
opportunity to introduce incremental
effectiveness and efficiency into the
compliance process—a migration that
will occur naturally as issuers and
auditors move forward on the learning
curve associated with reporting on
internal control over financial reporting.
Because I believe that compliance
with the provisions of Section 404
provides needed protection to investors
in all public companies, regardless of
size, I do not support recommendations
III.P.1, III.P.2, and III.P.3 in the Final
Report, as each would serve to dilute
this protection.
Specifically, Recommendation III.P.3
referencing a standard providing for an
audit of the design and implementation
of internal control, but not the testing by
the auditor of the operating
effectiveness, is in my view not
advisable. While clear disclosure that a
company has not undergone an audit of
internal control over financial reporting
is understandable to users, those same
users cannot be expected to assess the
relative gradations of assurance
provided by this proposed distinction in
reporting on internal control. An
alternative providing for an auditor’s
report only on design and
implementation of internal controls, at a
time when much attention has been
directed toward reporting on the
effective operation of internal controls,
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will result in users’ misunderstanding
the level of assurance provided by the
auditor. It is important to note that a
well-designed system of internal
control, while vital, does not equate to
the generation of reliable financial
information in the absence of effective
operation of internal control.
Accordingly, I believe that
Recommendation III.P.3 would serve to
widen an already existing expectation
gap with respect to audit services at a
time when emphasis should be directed
toward reducing that gap.
I do not support Recommendations
III.P.1 and III.P.2 based on my belief that
Section 404 of Sarbanes-Oxley has made
and will continue to make significant
contributions to improving financial
reporting, oversight of internal controls,
and audit quality. In my judgment,
sound public policy dictates that the
protections derived from these
contributions should be available to
investors in all public companies,
regardless of size.
I believe that compliance with the
provisions of Section 404 by issuers,
and application of the principles of
Auditing Standard No. 2 by auditors,
represent evolutionary skills that will
become more effective and efficient
with more experience. As noted above,
the effectiveness and cost-efficiencies of
Section 404 execution have improved
over the first two years. However,
additional efficiencies and experience
with Auditing Standard No. 2 are not
likely to fully address the concerns of
certain-sized smaller public companies.
Accordingly, I recommend that
regulators, issuers and the accounting
profession work expeditiously to
develop specific guidance, focused on
the characteristics of these smaller
companies and their internal control
structures, which will further improve
the execution of Section 404
compliance. I will commit resources of
my firm to participate in and support
this effort. Additional implementation
guidance specifically tailored to the
application of internal control concepts
in a smaller company environment
should, at a minimum, address the
following: significance of monitoring
controls, risk of management override,
lack of segregation of duties, extent and
formality of company documentation
and assessment, and evaluation of the
competency of a smaller company’s
accounting and financial reporting
function. This guidance should address
both the assessment to be made by
management and the auditor’s
performance requirements relevant to
such assessment, as well as the
execution of auditing procedures
pursuant to the provisions of Auditing
PO 00000
Frm 00044
Fmt 4701
Sfmt 4703
Standard No. 2. In addition, I believe
that field testing the effectiveness of this
additional guidance, including
appropriate cost analyses, should be
performed to facilitate well-informed
decisions regarding the reasonable
application of the provisions of Section
404 in a smaller public company
environment. It may become evident, as
a result of field testing and meaningful
cost analyses, that an audit of internal
control over financial reporting may not
be justified for certain very small public
companies that evidence certain
characteristics. For those smaller public
companies, an exemption from the
provisions of Section 404 may be
warranted, but such an exemption
should be considered only after careful
analysis of the data derived from the
field tests. In short, we simply do not
have sufficient implementation
guidance, experience, or information
available at this time to make a
permanent reduction in the protections
provided by Section 404.
It is essential that the additional
implementation guidance, specifically
tailored to the application of internal
control concepts in a smaller public
company environment, be developed
and tested expeditiously, given the
importance of this issue to smaller
public companies and investors. While
this guidance is being developed and
field tested, I recommend the continued
deferral of the Section 404 requirements
for all smaller public companies that
have not already been required to
implement Section 404. However, I
would envision that such deferral
would not extend more than a year
beyond the current implementation date
for non-accelerated filers.
It should be noted that this separate
statement focuses solely on the
recommendations to which I dissent,
and not to any specific statements or
opinions contained in the Final Report
which are inconsistent with my own
views.
The work of the Advisory Committee
and our Final Report has raised
important issues relative to application
of the provisions of Section 404. To
address those issues, I propose
additional guidance for smaller public
companies, and the field testing of that
guidance, relative to reporting on
internal control over financial reporting
as well as the continued deferral for
non-accelerated filers for an additional
year if these activities cannot be
completed within one year. I believe
these proposals are consistent with our
Charter to further the SEC’s investor
protection mandate, and to consider
whether the costs imposed by the
current regulatory system for small
E:\FR\FM\03MRN3.SGM
03MRN3
Federal Register / Vol. 71, No. 42 / Friday, March 3, 2006 / Notices
companies are proportionate to the
benefits, to identify methods of
minimizing costs and maximizing
benefits, and to facilitate capital
formation by smaller companies.
Appendices*
rwilkins on PROD1PC63 with NOTICES3
Index of Appendices
A. Official Notice of Establishment of
Committee
B. Committee Charter
C. Committee Agenda
D. SEC Press Release Announcing Intent to
Establish Committee
E. SEC Press Release Announcing Full
Membership of Committee
F. Committee By-Laws
VerDate Aug<31>2005
16:52 Mar 02, 2006
Jkt 205001
G. Request for Public Comments on
Committee Agenda
H. Request for Public Input
I. Background Statistics for All Public
Companies
J. Universe of Publicly Traded Equity
Securities and Their Governance
K. List of Witnesses
L. Letter from Committee Co-Chairs to SEC
Chairman Christopher Cox dated August
18, 2005
M. SEC Statement of Policy on Accounting
Provisions of Foreign Corrupt Practices Act
*Access to each appendix is available by
clicking its name on the copy of this page
posted on the Internet at www.sec.gov/info/
smallbus/acscp-finalreport_ed.pdf
PO 00000
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11133
Authority: In accordance with Section
10(a) of the Federal Advisory Committee Act,
5 U.S.C. App. 1, § 10(a), Gerald J. Laporte,
Designated Federal Officer of the Committee,
has approved publication of this release at
the request of the Committee. The action
being taken through the publication of this
release is being taken solely by the
Committee and not by the Commission. The
Commission is merely providing its facilities
to assist the Committee in taking this action.
Dated: February 28, 2006.
Nancy M. Morris,
Committee Management Officer.
[FR Doc. 06–1992 Filed 3–2–06; 8:45 am]
BILLING CODE 8010–01–U
E:\FR\FM\03MRN3.SGM
03MRN3
Agencies
[Federal Register Volume 71, Number 42 (Friday, March 3, 2006)]
[Notices]
[Pages 11090-11133]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 06-1992]
[[Page 11089]]
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Part IV
Securities and Exchange Commission
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Advisory Committee on Smaller Public Companies; Notice
Federal Register / Vol. 71, No. 42 / Friday, March 3, 2006 /
Notices
[[Page 11090]]
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SECURITIES AND EXCHANGE COMMISSION
[Release Nos. 33-8666; 34-53385; File No. 265-23]
Exposure Draft of Final Report of Advisory Committee on Smaller
Public Companies
AGENCY: Securities and Exchange Commission.
ACTION: Publication of Exposure Draft of Advisory Committee Final
Report, Request for Public Comment.
-----------------------------------------------------------------------
SUMMARY: The Securities and Exchange Commission Advisory Committee on
Smaller Public Companies is publishing an exposure draft of its Final
Report and requesting public comment on it.
DATES: Comments should be received on or before April 3, 2006.
ADDRESSES: Comments may be submitted by any of the following methods:
Electronic Statements
Use the Commission's Internet submission form (https://
www.sec.gov/info/smallbus/acspc.shtml); or
Send an e-mail message to rule-comments@sec.gov. Please
include File Number 265-23 on the subject line; or
Paper Comments
Send paper comments in triplicate to Nancy M. Morris,
Federal Advisory Committee Management Officer, Securities and Exchange
Commission, 100 F Street, NE., Washington, DC 20549-1090. You may also
fax your submission to 202-772-9324, Attn: Federal Advisory Committee
Management Officer.
All submissions should refer to File No. 265-23. This file number
should be included on the subject line if e-mail is used. To help us
process and review your comments more efficiently, please use only one
method. The Commission will post all comments on its Web site (https://
www.sec.gov./info/smallbus/acspc.shtml).
Comments also will be available for public inspection and copying
in the Commission's Public Reference Room, 100 F Street, NE.,
Washington, DC 20549. All comments received will be posted without
change; we do not edit personal identifying information from
submissions. You should submit only information that you wish to make
available publicly.
FOR FURTHER INFORMATION CONTACT: Questions about this release should be
referred to William A. Hines, Special Counsel, at (202) 551-3320, or
Kevin M. O'Neill, Special Counsel, at (202) 551-3260, Office of Small
Business Policy, Division of Corporation Finance, Securities and
Exchange Commission, 100 F Street, NE., Washington, DC 20549-3628.
SUPPLEMENTARY INFORMATION: The SEC Advisory Committee on Smaller Public
Companies is publishing an exposure draft of its Final Report to
solicit public comment on the draft. The draft contains proposed
recommendations of the Committee on improving the current securities
regulatory system for smaller companies. All interested parties are
invited to submit their comments in the manner described above. The
Advisory Committee is especially interested in receiving comments from
investors in microcap and smallcap companies, as well as from their
managements. The draft has been approved as an exposure draft by the
Advisory Committee. It does not necessarily reflect any position or
regulatory agenda of the Commission or its staff.
The text of the exposure draft follows:
Final Report of the Advisory Committee on Smaller Public Companies to
the U.S. Securities and Exchange Commission
[April 23], 2006
Table of Contents
Transmittal Letter
Members, Official Observers and Staff of Advisory Committee
Part I. Committee History
Part II. Scaling Securities Regulation for Smaller Companies
Part III. Internal Control Over Financial Reporting
Part IV. Capital Formation, Corporate Governance and Disclosure
Part V. Accounting Standards
Part VI. Epilogue
Part VII. Separate Statement of Mr. Jensen
Part VIII. Separate Statement of Mr. Schacht
Part IX. Separate Statement of Mr. Veihmeyer
Appendices*
A. Official Notice of Establishment of Committee
B. Committee Charter
C. Committee Agenda
D. SEC Press Release Announcing Intent To Establish Committee
E. SEC Press Release Announcing Full Membership of Committee
F. Committee By-Laws
G. Request for Public Comments on Committee Agenda
H. Request for Public Input
I. Background Statistics for All Public Companies
J. Universe of Publicly Traded Equity Securities and Their
Governance
K. List of Witnesses
L. Letter from Committee Co-Chairs to SEC Chairman Christopher
Cox dated August 18, 2005
M. SEC Statement of Policy on Accounting Provisions of Foreign
Corrupt Practices Act
*Access to each appendix is available by clicking its name on the
copy of this page posted on the Internet at https://www.sec.gov/info/
smallbus/acscp-finalreport_ed.pdf.
Transmittal Letter--SEC Advisory Committee on Smaller Public Companies
Washington, DC 20549-3628.
[April 23], 2006
The Honorable Christopher Cox, Chairman, U.S. Securities and
Exchange Commission, 100 F Street, NE, Washington, DC 20549-1070.
Dear Chairman Cox: On behalf of the Commission's Advisory
Committee on Smaller Public Companies, we are pleased to submit our
Final Report.
[Contents of letter to be included in Final Report.]
Respectfully submitted on behalf of the Committee.
Herbert S. Wander,
Committee Co-Chair.
James C. Thyen,
Committee Co-Chair.
Enclosure
cc: Commissioner Cynthia A. Glassman
Commissioner Paul S. Atkins
Commissioner Roel C. Campos
Commissioner Annette L. Nazareth; Ms. Nancy M. Morris
Members, Official Observers and Staff of Advisory Committee
Members
Herbert S. Wander, Co-Chair, Partner, Katten Muchin Zavis Rosenman (Ex
Officio Member of All Subcommittees and Size Task Force)
James C. Thyen, Co-Chair, President and CEO, Kimball International,
Inc. (Ex Officio Member of All Subcommittees, Chairperson of Size Task
Force)
Patrick C. Barry, Chief Financial Officer and Chief Operating Officer,
Bluefly, Inc. (Accounting Standards Subcommittee, Size Task Force)
Steven E. Bochner, Partner, Wilson Sonsini Goodrich & Rosati,
Professional Corporation (Chairperson, Corporate Governance and
Disclosure Subcommittee)
Richard D. Brounstein, Executive Vice President and Chief Financial
Officer, Calypte Biomedical Corp. (Internal Control Over Financial
Reporting Subcommittee)
C.R. ``Rusty'' Cloutier, President and Chief Executive Officer,
MidSouth Bancorp, Inc. (Corporate Governance and Disclosure
Subcommittee)
James A. ``Drew'' Connolly III, President, IBA Capital Funding (Capital
Formation Subcommittee)
E. David Coolidge III, Vice Chairman, William Blair & Company
(Chairperson, Capital Formation Subcommittee)
Alex Davern, Chief Financial Officer and Senior Vice President of
[[Page 11091]]
Manufacturing and Information Technology Operations, National
Instruments Corp. (Internal Control Over Financial Reporting
Subcommittee, Size Task Force)
Joseph ``Leroy'' Dennis, Executive Partner, McGladrey & Pullen
(Chairperson, Accounting Standards Subcommittee)
Janet Dolan, Former Chief Executive Officer, Tennant Company
(Chairperson, Internal Control Over Financial Reporting Subcommittee)
Richard M. Jaffee, Chairman of the Board, Oil-Dri Corporation of
America (Corporate Governance and Disclosure Subcommittee, Size Task
Force)
Mark Jensen, National Director, Venture Capital Services, Deloitte &
Touche (Internal Control Over Financial Reporting Subcommittee)
Deborah D. Lambert, Co-Founder, Johnson Lambert & Co. (Internal Control
Over Financial Reporting Subcommittee)
Richard M. Leisner, Partner, Trenam Kemker (Capital Formation
Subcommittee, Size Task Force)
Robert E. Robotti, President and Managing Director, Robotti & Company,
LLC (Corporate Governance and Disclosure Subcommittee)
Scott R. Royster, Executive Vice President & Chief Financial Officer,
Radio One, Inc. (Capital Formation Subcommittee)
Pastora San Juan Cafferty, Professor, School of Social Service
Administration, University of Chicago (Corporate Governance and
Disclosure Subcommittee)
Kurt Schacht, Executive Director, CFA Centre for Financial Market
Integrity (Internal Control Over Financial Reporting Subcommittee)
Ted Schlein, Managing Partner, Kleiner Perkins Caufield & Byers
(Capital Formation Subcommittee)
John B. Veihmeyer, Deputy Chairman, KPMG LLP (Accounting Standards
Subcommittee)
Official Observers
George J. Batavick, Member, Financial Accounting Standards Board (FASB)
(Accounting Standards Subcommittee)
Daniel L. Goelzer, Member, Public Company Accounting Oversight Board
(Internal Control Over Financial Reporting Subcommittee)
Jack E. Herstein, Assistant Director, Nebraska Bureau of Securities
(Capital Formation Subcommittee)
SEC Staff
Alan L. Beller, Director (until February 2006) Division of Corporation
Finance
Martin P. Dunn, Deputy Director, Division of Corporation Finance
Mauri L. Osheroff, Associate Director (Regulatory Policy), Division of
Corporation Finance
Gerald J. Laporte, Committee Staff Director Chief, Office of Small
Business Policy, Division of Corporation Finance
Kevin M. O'Neill, Committee Deputy Staff Director, Special Counsel,
Office of Small Business Policy, Division of Corporation Finance
Cindy Alexander, Assistant Chief Economist, Corporate Finance and
Disclosure, Office of Economic Analysis
Anthony G. Barone, Special Counsel, Office of Small Business Policy,
Division of Corporation Finance
Jennifer Burns, Public Accounting Fellow, Office of the Chief
Accountant
Mark W. Green, Senior Special Counsel, Division of Corporation Finance
Kathleen Weiss Hanley, Economic Fellow, Office of Economic Analysis
William A. Hines, Special Counsel, Office of Small Business Policy,
Division of Corporation Finance
Alison Spivey, Associate Chief Accountant, Office of the Chief
Accountant
Executive Summary \1\
Background
The U.S. Securities and Exchange Commission (the ``Commission'' or
``SEC'') chartered the Advisory Committee on Smaller Public Companies
on March 23, 2005. The Charter provided that our objective was to
assess the current regulatory system for smaller companies under the
securities laws of the United States, and make recommendations for
changes. The Charter also directed that we specifically consider the
following areas of inquiry, including the impact in each area of the
Sarbanes-Oxley Act of 2002: \2\
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\1\ This report has been approved by the Committee and reflects
the views of a majority of its members. It does not necessarily
reflect any position or regulatory agenda of the Commission or its
staff.
Note on Terminology: To aid understanding and improve
readability, we have tried to avoid using defined terms with initial
capital letters in this report. We generally use the terms ``public
company'' and ``reporting company'' interchangeably to refer to any
company that is required to file annual and quarterly reports with
the SEC in accordance with either Section 13 or 15(d) of the
Securities Exchange Act of 1934, 15 U.S.C. 78m or 78o(d). When we
refer to ``microcap companies,'' we are referring to public
companies with equity capitalizations of approximately $128 million
or less. When we discuss ``smallcap companies,'' we are talking
about public companies with equity capitalizations of approximately
$128 million to $787 million. We believe these labels generally are
consistent with securities industry custom and usage. When we refer
to ``smaller public companies,'' we are referring to public
companies with equity capitalizations of approximately $787 million
and less, which includes both microcap and smallcap companies. We
recognize that formal legal definitions of these terms may be
necessary to implement some of our recommendations that use them,
and we discuss our recommendations as to how some of them should be
defined in Part II.
\2\ Pub. L. No. 107-204, 116 Stat. 745 (July 30, 2002).
---------------------------------------------------------------------------
Frameworks for internal control over financial reporting
applicable to smaller public companies, methods for management's
assessment of such internal control, and standards for auditing such
internal control;
Corporate disclosure and reporting requirements and
federally imposed corporate governance requirements for smaller public
companies, including differing regulatory requirements based on market
capitalization, other measurements of size or market characteristics;
Accounting standards and financial reporting requirements
applicable to smaller public companies; and
The process, requirements and exemptions relating to
offerings of securities by smaller companies, particularly public
offerings.
The Charter further directed us to conduct our work with a view to
furthering the Commission's investor protection mandate, and to
consider whether the costs imposed by the current regulatory system for
smaller companies are proportionate to the benefits, identify methods
of minimizing costs and maximizing benefits and facilitate capital
formation by smaller companies. The language of our Charter specified
that we should consider providing recommendations as to where and how
the Commission should draw lines to scale regulatory treatment for
companies based on size.
Our chartering documents \3\ purposely did not define the phrase
``smaller public company.'' Rather, it was intended that we recommend
how the term should be defined. In addition, we were advised that we
were charged with assessing the securities regulatory system for all
smaller companies, both public and private, and were not limited to
considering regulations applicable to public companies. The
Commissioners and the SEC staff did advise us, however, that they hoped
we would focus primarily on public companies, because of the apparent
need for prompt attention to that area of concern, especially in view
of problems in implementing the Sarbanes-Oxley Act of 2002.
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\3\ The official notice of establishment of the Committee and
its Charter, included in this report as Appendices A and B,
respectively, constitute our chartering documents.
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[[Page 11092]]
Our 21 members voted unanimously on April 20, 2006 to adopt this
Final Report and transmit it to the Commission. The recommendations set
forth in this report were for the most part adopted unanimously. Where
one or more members dissented or, while present, abstained from voting
with respect to a specific recommendation, that fact has been noted in
the text. Additionally, Parts VII, VIII and IX of this report contains
separate statements submitted by Mark Jensen, Kurt Schacht and John B.
Veihmeyer that describe briefly their reasons for disagreeing with
specific recommendations of the majority of our voting members.
Recommendations
Our final recommendations are discussed in the remainder of this
report. Before summarizing our highest priority recommendations below,
we would like to explain why we have presented them in the order that
we have. As detailed under the caption ``Part I--Committee History--
Committee Activities,'' we conducted most of our preliminary
deliberations in four subcommittees, and a ``size task force''
comprised of a representative of each subcommittee and Committee Co-
Chair James C. Thyen, who chaired the size task force. The
subcommittees and the size task force generated preliminary
recommendations that were discussed and approved by the full Committee.
We agreed at our meeting on April 20, 2006 to submit to the Commission
the 32 final recommendations contained in this report.\4\
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\4\ This does not include two recommendations, which the
Committee adopted on August 10, 2005 and submitted to the Commission
in a separate report dated August 18, 2005 (included as Appendix L
of this report and discussed therein). The Commission acted
favorably upon these two recommendations in September 2005. See
Revisions to Accelerated Filer Definition and Accelerated Deadlines
for Filing Periodic Reports, SEC Release No. 33-8617 (Sept. 22,
2005); Management's Report on Internal Over Financial Reporting and
Certification of Disclosure in Exchange Act Reports of Companies
that are Not Accelerated Filers, SEC Release No. 33-8618 (Sept. 22,
2005).
---------------------------------------------------------------------------
We recognize that it is unlikely that the Commission and its staff
will be able to consider, much less act upon, all 32 of these
recommendations at once. Furthermore, submitting such a large number of
recommendations, without any indication of the importance or priority
we ascribe to them, might make the Commission less likely to act upon
recommendations in areas where we believe the need for action is most
urgent. Accordingly, we have adopted a two-tiered approach towards the
prioritization of our recommendations.
The first tier--the recommendations to which we assign the highest
priority--we refer to as our ``primary recommendations.'' Our primary
recommendations are set forth under the specific topic to which they
relate: Our recommendation concerning establishment of a scaled
securities regulation system is discussed under the caption ``Part II.
Scaling Securities Regulation for Smaller Companies''; recommendations
related to internal control over financial reporting are discussed
under the caption ``Part III. Internal Control Over Financial
Reporting''; capital formation, corporate governance and disclosure
recommendations are discussed under the caption ``Part IV. Capital
Formation, Corporate Governance and Disclosure''; and accounting
standards recommendations are discussed under the caption ``Part V.
Accounting Standards.''
Before addressing our recommendations, the Committee wishes to
emphasize that each of our members fully embraces the concepts of good
governance and transparency. We believe our recommendations are
designed to further these goals while establishing cost effective
methods of achieving them.
Our first primary recommendation concerns establishment of a new
system of scaled or proportional securities regulation for smaller
public companies based on a stratification of smaller public companies
into two groups, microcap companies and smallcap companies. Under this
recommendation, microcap companies would consist of companies whose
outstanding common stock (or equivalent) in the aggregate comprises the
lowest 1% of total U.S. equity market capitalization, and smallcap
companies would consist of companies whose outstanding common stock (or
equivalent) in the aggregate comprises the next lowest 5% of total U.S.
equity market capitalization. Smaller public companies, consisting of
microcap and smallcap companies, would thus in the aggregate comprise
the lowest 6% of total U.S. equity market capitalization. While they
account for only a small percentage of total U.S. equity market
capitalization, these companies represent a substantial percentage of
all U.S. public companies, as shown in the table below:
----------------------------------------------------------------------------------------------------------------
Percentage of
Market total U.S. Percentage of
capitalization equity market all U.S. public
cutoff (million) capitalization companies
----------------------------------------------------------------------------------------------------------------
Microcap Companies........................................ $128.2 1 52.6
Smallcap Companies........................................ 128.2-787.1 5 25.9
Smaller Public Companies.................................. <787.1 6 78.5
Larger Public Companies................................... >787.1 94 21.5
----------------------------------------------------------------------------------------------------------------
Source: SEC Office of Economic Analysis, Background Statistics: Market Capitalization and Revenue of Public
Companies, Table 2 (Aug. 2, 2005) (included as Appendix I). Table includes only the 9,428 U.S. companies
listed on the New York and American Stock Exchanges, the NASDAQ Stock Market and the OTC Bulletin Board, with
a total market capitalization of $16,891 million as of June 10, 2005. Table does not include the approximately
4,586 securities of 4,504 U.S. public companies whose stock trades only on the Pink Sheets, a number of which
are not required to file annual and quarterly reports with the SEC in accordance with either Section 13 or
15(d) of the Securities Exchange Act of 1934 and accordingly do not fall within the definition of ``public
company'' as used in this report. The omission of data concerning Pink Sheets companies understates the
percentage of U.S. public companies represented by microcap companies. See Appendix J.
We believe that the Commission should establish this scaled system
before or in connection with proceeding to examine individual
securities regulations to determine whether they are candidates for
integration of scaling treatment under the new system. Because of its
significance, we felt that this recommendation merited discussion under
a separate caption. Accordingly, we discuss this recommendation and our
thoughts about implementing in this approach ``Part II. Scaling
Securities Regulation for Smaller Companies.''
Below is a list of our remaining primary recommendations, and the
[[Page 11093]]
location in this report where they are described in greater detail: \5\
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\5\ We have labeled our recommendations by section in which
their full description appears, status (either primary (P) or
secondary (S)), and rank within a given section. Hence the first
primary recommendation in Part III is Recommendation III.P.1; the
third secondary recommendation in Part IV is Recommendation IV.S.3,
etc.
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Establish a new system of scaled or proportional
securities regulation for smaller public companies using the following
six determinants to define a ``smaller public company'':
[ssbox] The total market capitalization of the company;
[ssbox] A measurement metric that facilitates scaling of
regulation;
[ssbox] A measurement metric that is self-calibrating;
[ssbox] A standardized measurement and methodology for
computing market capitalization;
[ssbox] A date for determining total market
capitalization; and
[ssbox] Clear and firm transition rules, i.e., small to
large and large to small (Recommendation II.P.1).
Develop specific scaled or proportional regulation for companies
under the system if they qualify as ``microcap companies'' because
their equity market capitalization places them in the lowest 1% of
total U.S. equity market capitalization or as ``smallcap companies''
because their equity market capitalization places them in the next
lowest 1% to 5% of total U.S. equity market capitalization, with the
result that all companies comprising the lowest 6% would be considered
for scaled or proportional regulation.
Unless and until a framework for assessing internal
control over financial reporting for microcap companies is developed
that recognizes the characteristics and needs of those companies,
provide exemptive relief from the requirements of Section 404 of the
Sarbanes-Oxley Act \6\ to microcap companies with less than $125
million in annual revenue and to smallcap companies with less than $10
million in annual product revenue that have or expand their corporate
governance controls to include:
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\6\ 15 U.S.C. 7262.
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[ssbox] Adherence to standards relating to audit committees in
conformity with Rule 10A-3 under the Securities Exchange Act of 1934;
\7\ and
---------------------------------------------------------------------------
\7\ 15 U.S.C. 78a et seq.
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Adoption of a code of ethics within the meaning of Item
406 of Regulation S-K \8\ applicable to all directors, officers and
employees and compliance with the further obligations under Item 406(c)
relating to the disclosure of the code of ethics.
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\8\ 17 CFR 229.
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In addition, as part of this recommendation, we recommend that the
Commission confirm, and if necessary clarify, the application to all
microcap companies, and indeed to all smallcap companies also, the
existing general legal requirements regarding internal controls,
including the requirement that companies maintain a system of effective
internal control over financial reporting, disclose modifications to
internal control over financial reporting and their material
consequences, and apply CEO and CFO certifications to such disclosures.
Moreover, management should be required to report on any known material
weaknesses. In this regard, the Proposed Statement on Auditing
Standards of the AICPA, ``Communications of Internal Control Related
Matters Noted in an Audit,'' if adopted by the AICPA and the Public
Company Accounting Oversight Board (PCAOB), would strengthen this
disclosure requirement and provide some external auditor involvement in
the internal control over financial reporting process. (Recommendation
III.P.1).
Unless and until a framework for assessing internal
control over financial reporting for smallcap companies is developed
that recognizes the characteristics and needs of those companies,
provide exemptive relief from external auditor involvement in the
Section 404 process to smallcap companies with less than $250 million
but greater than $10 million in annual product revenues, subject to
their compliance with the same corporate governance standards detailed
in the recommendation above (Recommendation III.P.2).
While we believe that the costs of the requirement for an
external audit of the effectiveness of internal control over financial
reporting are disproportionate to the benefits, and have therefore
adopted the second Section 404 recommendation above, we also believe
that if the Commission reaches a public policy conclusion that an audit
requirement is required, we recommend that changes be made to the
requirements for implementing Section 404's external auditor
requirement to a cost-effective standard, which we call ``ASX,''
providing for an external audit of the design and implementation of
internal controls (Recommendation III.P.3).
Incorporate the scaled disclosure accommodations currently
available to small business issuers under Regulation S-B into
Regulation S-K, make them available to all microcap companies, and
cease prescribing separate specialized disclosure forms for smaller
companies (Recommendation IV.P.1).
Incorporate the primary scaled financial statement
accommodations currently available to small business issuers under
Regulation S-B into Regulation S-K or Regulation S-X and make them
available to all microcap and smallcap companies (Recommendation
IV.P.2).
Allow all reporting companies listed on a national
securities exchange, NASDAQ or the OTC Bulletin Board to be eligible to
use Form S-3, if they have been reporting under the Exchange Act for at
least one year and are current in their reporting at the time of filing
(Recommendation IV.P.3).
Adopt policies that encourage and promote the
dissemination of research on smaller public companies (Recommendation
IV.P.4).
Adopt a new private offering exemption from the
registration requirements of the Securities Act of 1933 (the
``Securities Act'') \9\ that does not prohibit general solicitation and
advertising for transactions with purchasers who do not need all the
protections of the Securities Act's registration requirements.
Additionally, relax prohibitions against general solicitation and
advertising found in Rule 502(c) under the Securities Act to parallel
the ``test the waters'' model of Rule 254 under that Act
(Recommendation IV.P.5).
---------------------------------------------------------------------------
\9\ 15 U.S.C. 77a et seq.
---------------------------------------------------------------------------
Spearhead a multi-agency effort to create a streamlined
NASD registration process for finders, M&A advisors and institutional
private placement practitioners (Recommendation IV.P.6).
Develop a ``safe-harbor'' protocol for accounting for
transactions that would protect well-intentioned preparers from
regulatory or legal action when the process is appropriately followed
(Recommendation V.P.1).
In implementing new accounting standards, the FASB should
permit microcap companies to apply the same extended effective dates
that it provides for private companies (Recommendation V.P.2).
Consider additional guidance for all public companies with
respect to materiality related to previously issued financial
statements (Recommendation V.P.3).
Implement a de minimis provision in the application of the
SEC's auditor independence rules (Recommendation V.P.4).
Our second tier consists of all of the remaining recommendations,
which we
[[Page 11094]]
refer to in this report as ``secondary recommendations.'' Although we
have assigned these a lower priority than the recommendations set forth
above, we do not in any way intend to diminish their importance. In
this regard, we note that importance is at times not only a function of
the perceived need for change but also the perceived ease with which
the Commission could enact such change; as noted throughout the report,
many problems simply defy easy solution. Moreover, several of these
recommendations are aspirational in nature, and do not involve specific
Commission action. As with the primary recommendations, these secondary
recommendations are set forth under the specific topics to which they
relate, and within each such section, recommendations are presented in
descending order of importance (i.e., the secondary recommendation that
we would most like to see adopted is listed first, etc.).
Part I. Committee History
On December 16, 2004, then SEC Chairman William H. Donaldson
announced the Commission's intent to establish the SEC Advisory
Committee on Smaller Public Companies.\10\ At the same time, Chairman
Donaldson announced his intention to name Herbert S. Wander and James
C. Thyen as Co-Chairs of the Committee. The official notice of our
establishment was published in the Federal Register five days
later.\11\ The Committee's membership was completed on March 7, 2005,
with members drawn from a wide range of professions, backgrounds and
experiences.\12\ The Committee's Charter was filed with the Senate
Committee on Banking, Housing and Urban Affairs and the House Committee
on Financial Services on March 23, 2005, initiating our 13-month
existence.\13\
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\10\ SEC Establishes Advisory Committee to Examine Impact of
Sarbanes-Oxley Act on Smaller Public Companies, SEC Press Release
No. 2004-174 (Dec. 16, 2004) (included as Appendix D).
\11\ Advisory Committee on Smaller Public Companies, SEC Release
No. 33-8514 (Dec. 21, 2004) [69 FR 76498] (included as Appendix B).
\12\ SEC Chairman Donaldson Announces Members of Advisory
Committee on Smaller Public Companies, SEC Press Release No. 2005-30
(Mar. 7, 2005) (included as Appendix E). This press release
describes the diverse backgrounds of the Committee members.
\13\ See Committee Charter (included as Appendix B).
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Committee Activities
We held our organizational meeting on April 12, 2005 in Washington,
DC, where Chairman Donaldson swore in and addressed our members. Also
at that meeting, we adopted our by-laws, proposed a Committee Agenda to
be published for public comment \14\ and reviewed a subcommittee
structure and Master Schedule prepared by our Co-Chairs. This and all
of our subsequent meetings were open to the public and conducted in
accordance with the requirements of the Federal Advisory Committee
Act.\15\ All meetings of the full Committee also were Web cast over the
Internet.
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\14\ The Record of Proceedings of this and subsequent meetings
of the Committee are available on our Web site at https://
www.sec.gov/info/smallbus/ascpc.shtml. See Record of Proceedings,
Meeting of the Securities and Exchange Commission Advisory Committee
on Smaller Public Companies (Apr. 12, June 16, June 17, Aug. 9, Aug.
10, Sept. 19, Sept. 20, Oct. 24, Oct. 25 & Dec. 14, 2005 & Feb. 21,
Apr. 11 & Apr. 20, 2006) (on file in SEC Public Reference Room File
No. 265-23), available at https://www.sec.gov/info/smallbus/
ascpc.shtml (hereinafter Record of Proceedings (with appropriate
date)).
\15\ 5 U.S.C.--App. 1 et seq.
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Shortly following our formation, we adopted several overarching
principles to guide our efforts:
Further Commission's investor protection mandate.
Seek cost choice/benefit inputs.
Keep it simple.
Maintain culture of entrepreneurship.
Capital formation should be encouraged.
Recommendations should be prioritized.
We held subsequent meetings in 2005 on June 16 and 17 in New York
City, August 9 and 10 in Chicago, September 19 and 20 in San Francisco,
and October 14 again in New York City. A total of 42 witnesses
testified at these meetings.\16\ We adopted our Committee Agenda at the
June 16 meeting in New York.\17\ We adopted two recommendations to the
Commission at our Chicago meeting, where we also adopted an internal
working definition of the term ``smaller public company.'' \18\ We held
additional meetings in Washington on October 24 and 25 and December 14,
2005 and February 21, 2006 to consider and vote on recommendations and
the draft of our final report to the Commission. SEC Chairman
Christopher Cox, who had succeeded Chairman Donaldson on August 3,
2005, addressed us at the October 24 meeting in Washington. No
witnesses testified at the additional meetings in Washington.
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\16\ Appendix K contains a list of witnesses who testified
before the Committee.
\17\ The Committee Agenda is included as Appendix C.
\18\ The Chicago recommendations were submitted to the
Commission by letter dated August 18, 2005 to SEC Chairman
Christopher Cox, who had succeeded Chairman Donaldson. The text of
the letter is included as Appendix L. The letter included copies of
documents entitled ``Six Determinants of a Smaller Public Company''
and ``Definition of Smaller Public Company,'' which had been made
available to the Committee before it adopted its definition of the
term ``smaller public company.''
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The Committee, through the Commission, published three releases in
the Federal Register formally seeking public comment on issues it was
considering. On April 29, 2005, we published a release seeking comments
on our proposed Committee Agenda,\19\ in response to which we received
---- written submissions. On August 2, 2005, we published 29 questions
on which we sought public input, to which we received 266
responses.\20\ Finally, on ------ ------, 2006, we published an
exposure draft of our final report,\21\ which generated ---- written
submissions. In addition, each meeting of the Committee was announced
by formal notice in a Federal Register release, and each such notice
included an invitation to submit written statements to be considered in
connection with the meeting. In total, we received ---- written
statements in response to Federal Register releases.\22\
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\19\ Summary of Proposed Committee Agenda of Advisory Committee
on Smaller Public Companies, SEC Release No. 33-8571, (Apr. 29,
2005) [70 FR 22378].
\20\ See Request for Public Input by Advisory Committee on
Smaller Public Companies, SEC Release No. 33-8599 (Aug. 5, 2005) [70
FR 45446] (included as Appendix H).
\21\ ---- -------- ----, SEC Release No. 33----- (2006).
\22\ All of the written submissions made to the Committee are
available in the SEC's Public Reference Room in File No. 265-23 and
on the Committee's Web page at https://www.sec.gov/rules/other/265-
23.shtml. To avoid duplicative material in footnotes, citations to
the written submissions made to the Committee in this Final Report
do not reference the Public Reference Room or repeat the Public
Reference Room file number.
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In addition to work carried out by the full Committee, fact finding
and deliberations also took place within four subcommittees appointed
by our Co-Chairs. The subcommittees were organized according to their
principal areas of focus: Accounting Standards, Capital Formation,
Corporate Governance and Disclosure, and Internal Control Over
Financial Reporting. Each of the subcommittees prepared recommendations
for consideration by the full Committee. We approved preliminary
versions of most recommendations at our December 14, 2005 meeting. A
fifth subgroup, sometimes referred to as the ``size task force'' in our
deliberations, consisted of one volunteer from each subcommittee and
our Co-Chair James C. Thyen. The size task force met to consider common
issues faced by the subcommittees relating to establishment of
parameters for eventual recommendations on
[[Page 11095]]
scalability of regulations based on company size. The task force
developed internal working guidelines for the subcommittees to use for
this purpose and reported them to the full Committee at our August 10,
2005 meeting.\23\ We voted to approve the guidelines, which are
discussed in the next part of this report.
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\23\ See Record of Proceedings 62-103 (Aug. 10, 2005).
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Part II. Scaling Securities Regulation for Smaller Companies
We developed a number of recommendations concerning the
Commission's overall policies relating to the scaling of securities
regulation for smaller public companies. As discussed below, we believe
that these recommendations are fully consistent with the original
intent and purpose of our Nation's securities laws.\24\ We believe
that, over the years, some of the original principles underlying our
securities laws, including proportionality, have been underemphasized,
and that the Commission should seek to restore balance in these areas
where appropriate.
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\24\ For background on the history of scaling federal securities
regulation for smaller companies, see the discussion under the
caption ``--Commission Has a Long History of Scaling Regulation''
below.
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Our primary recommendation concerning scaling, and one that
underlies several other recommendations that follow in this report, is
as follows:
Recommendation II.P.1
Establish a new system of scaled or proportional securities
regulation for smaller public companies using the following six
determinants to define a ``smaller public company'':
The total market capitalization of the company;
[ssbox] A measurement metric that facilitates scaling of
regulation;
[ssbox] A measurement metric that is self-calibrating;
[squf] A standardized measurement and methodology for
computing market capitalization;
[squf] A date for determining total market
capitalization; and
[squf] Clear and firm transition rules, i.e., small to
large and large to small.
Develop specific scaled or proportional regulation for companies
under the system if they qualify as ``microcap companies'' because
their equity market capitalization places them in the lowest 1% of
total U.S. equity market capitalization or as ``smallcap companies''
because their equity market capitalization places them in the next
lowest 1% to 5% of total U.S. equity market capitalization, with the
result that all companies comprising the lowest 6% would be considered
for scaled or proportional regulation.\25\
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\25\ Mr. Schacht abstained from voting on this recommendation.
All other members present voted in favor of this recommendation.
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This new system would replace the SEC's current scaling system for
``small business issuers'' eligible to use Regulation S-B \26\ as well
as the current scaling system based on ``non-accelerated filer''
status,\27\ but would provide eligibility for scaled regulation for
companies based on their size relative to larger companies.\28\
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\26\ Regulation S-B can be found at 17 CFR 228.
\27\ ``Non-accelerated filers'' are public companies that do not
qualify as ``accelerated filers'' under the SEC's definition of the
latter term in 17 CFR 240.12b-2, generally because they have a
public float of less than $75 million. Companies that do not qualify
as accelerated filers have more time to file their annual and
quarterly reports with the SEC and have not yet been required to
comply with the internal control over financial reporting
requirements of Sarbanes-Oxley Act Section 404.
\28\ We believe our recommended system complements the SEC's
recently promulgated securities offering reforms, which are
principally available to a category of public companies with over
$700 million in public float known as ``well-known seasoned
issuers.'' We recognize, however, that the Commission will need to
assure that our recommendations, if adopted, are integrated well
with the categories of companies established in the securities
offering reform initiatives.
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Under our recommended system, companies would be eligible for
special scaled or proportional regulation if they fall into one of two
categories of smaller public companies based on size. We call one
category ``microcap companies'' and the other ``smallcap companies.''
Both categories of companies would be included in the category of
``smaller public companies'' that qualify for the new scaled regulatory
system. Companies whose common stock (or equivalent) in the aggregate
comprises the lowest 1% of total U.S. equity market capitalization
(companies with equity capitalizations below approximately $128 million
\29\) would qualify as microcap companies. Companies whose common stock
(or equivalent) in the aggregate comprises the next lowest 5% of total
U.S. equity market capitalization (companies with equity
capitalizations between approximately $128 million and $787 million)
generally would qualify as smallcap companies.\30\ Smallcap companies
would be entitled to the regulatory scaling provided by SEC regulations
for companies of that size after study of their characteristics and
special needs.
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\29\ SEC Office of Economic Analysis, Background Statistics:
Market Capitalization and Revenue of Public Companies (Aug. 2, 2005)
(included as Appendix I). Data was derived from Center for Research
in Security Prices (CRSP) for 9,428 New York and American Stock
Exchange companies as of March 31, 2005 and from NASDAQ for NASDAQ
Stock Market and OTC Bulletin Board firms as of June 10, 2005.
\30\ Id.
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Under the system we are recommending, microcap companies generally
would be entitled to the accommodations afforded to small business
issuers and non-accelerated filers under the SEC's current rules.
Smallcap companies would be entitled to whatever accommodations the SEC
decides to provide them in the future. As discussed below, we are
recommending that the SEC provide certain relief under Sarbanes-Oxley
Act Section 404 to certain smaller public companies.\31\ We also are
recommending that the SEC permit smaller public companies to follow the
financial statement rules now followed by small business issuers under
Item 310 of Regulation S-B rather than the financial statement rules in
Regulation S-X currently followed by all companies that are not small
business issuers.\32\
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\31\ See the discussion in Part III below.
\32\ See the discussion in Part IV below.
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Our primary reason for recommending special scaled regulation for
companies falling in the aggregate in the lowest 6% of total U.S.
equity market capitalization is that this cutoff assures the full
benefits and protection of federal securities regulation for companies
and investors in 94% of the total public U.S. equity capital
markets.\33\ This limits risk and exposure to investors and protects
investors from serious losses (e.g., 100 bankruptcies companies with
$10 million total market capitalization would be required to equal the
potential loss of the bankruptcy of a company with $1 billion of market
capitalization). Our recommended standard acknowledges the relative
risk to investors and the capital markets as it is currently used by
professional investors.
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\33\ We recognize that, if the Commission determines to
implement our recommendation, it may want to examine the
distinguishing characteristics of the group of ``smaller public
companies'' to which it intends to provide specific regulatory
relief. We have done this in developing our recommendations set out
in ``Part III. Internal Control Over Financial Reporting.'' A
comment letter recently sent to the Commission also went through
this exercise in making recommendations with respect to application
of Section 404 of the Sarbanes-Oxley Act to smaller public
companies. See Letter from BDO Seidman, LLP, at 2-3 (Oct. 31, 2005)
(on file in SEC Public Reference Room File No. S7-06-03), available
at https://www.sec.gov/rules/proposed/s70603/bdoseidman103105.pdf.
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In addition, we considered the SEC's recent adoption of rules
reforming the
[[Page 11096]]
securities offering process.\34\ Reporting companies with a public
float of $700 million or more, called ``well-known seasoned issuers,''
generally will be permitted to benefit to the greatest degree from
securities offering reform. We are hopeful that the Commission will see
fit to adopt a disclosure system applicable to ``smaller public
companies'' that integrates well with the disclosure and other rules
applicable to ``well-known seasoned issuers.'' We believe that
companies that qualify as ``smaller public companies'' on the basis of
equity market capitalization should not also qualify as ``well-known
seasoned issuers.''
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\34\ See Securities Offering Reform, SEC Release No. 33-8591
(July 19, 2005) [70 FR 44722].
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We recommend that the SEC implement this recommendation by
promulgating regulations under which all U.S. companies with equity
securities registered under the Exchange Act would be ranked from
largest to smallest equity market capitalization at each recalculation
date.\35\ The ranges of market capitalizations entitling public
companies to qualify as a ``microcap company'' and ``smallcap company''
would be published soon after the recalculation. These ranges would
remain valid until the next recalculation date. Companies would be able
to determine whether they qualify for microcap and smallcap company
treatment by comparing their market capitalization on their
determination date, presumably the last day of their previous fiscal
year, with the ranges published by the SEC for the most recent
recalculation date.\36\ The determination so would then be used to by
companies to determine their status for the next fiscal year. This is
what we mean when we say that the measurement metric for determining
smaller public company status should be ``self-calibrating.''
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\35\ We leave to the Commission's discretion the frequency with
which this recalculation should occur, but note that frequent
recalculation, even on an annual basis, could introduce an
undesirable level of uncertainty into the process for companies
trying to determine where they fall within the three categories.
\36\ In formulating this recommendation, we looked for guidance
at the method used to calculate the Russell U.S. Equity Indexes. For
more information on Russell's method, see Russell U.S. Equity
Indexes, Construction and Methodology (July 2005)), available at
www.russell.com.
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In promulgating these rules, the SEC will need to establish clear
transition rules providing how companies would graduate from the
microcap category to the smallcap category to the realm where they
would not be entitled to smaller public company scaling. The transition
rules would also need to specify how companies would move from one
category to another in the reverse order, from no scaling entitlement
to smallcap company treatment to microcap entitlement. The SEC has
experience and precedents to follow in its transition rules governing
movement to and from Regulation S-B and Regulation S-K, non-accelerated
filer status and accelerated filer status, and well-known seasoned
issuer eligibility and non-eligibility.
We believe that our plan for providing scaled regulatory treatment
for smaller public companies contains features that recommend it over
some other SEC regulatory formats. For example, it provides for a
flexible measurement that can move up and down, depending on stock
price and other market levels. It avoids the problem of setting a
dollar amount standard that needs to be revisited and rewritten from
time to time, and consequently provides a long-term solution to the
problem of re-scaling securities regulation for smaller public
companies every few years. Finally, assuming the plan is implemented as
we intend, the system would provide full transparency and allow each
company and its investors to determine the company's status in advance
or at any time based on publicly available information. This would
allow companies to plan for transitions suitably in advance of
compliance with new regulations.
We recommend that the SEC use equity market capitalization, rather
than public float, to determine eligibility for smaller public company
treatment for several reasons.\37\ We are aware that the SEC
historically has used public float as a measurement in analogous
regulatory contexts.\38\ However, we recommend that the SEC use equity
capitalization, rather than public float, to determine eligibility for
smaller public companies for several reasons. First, we believe that
equity market capitalization better measures total risk to investors
(including affiliates, some of whom may not have adequate access to
information) and the U.S. capital markets than public float, and
consequently that it is the most relevant measure in determining which
companies initially should qualify for scaled securities regulatory
treatment based on size. We also believe that using market
capitalization has the additional advantage of simplicity, as it avoids
what can be the difficult problem of deciding for legal purposes which
holdings are public float and which are not.\39\ This can be a
subjective determination; not all companies reach the same conclusions
on this issue based on similar facts, which can lead to problems of
comparability.
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\37\ The Commission would, of course, need to prescribe a
standardized methodology for computing market capitalization.
\38\ For example, a public float test is used to determine a
company's eligibility to use Forms SB-2, F-3 and S-3 and non-
accelerated filer status.
\39\ Because public float by definition excludes shares held by
affiliates, calculation of public float relies upon an accurate
assessment of affiliate status of officers, directors and
shareholders. As the Commission acknowledged in the Rule 144
context, this requires a subjective, facts and circumstances
determination that entails a great deal of uncertainty. See Revision
of Rule 144, Rule 145 and Form 144, SEC Release No. 33-7391 (Feb.
20, 1997) [62 FR 9246].
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In formulating our scaling recommendation, we considered a number
of alternatives to market capitalization as the primary metric for
determining eligibility for scaling, including revenues. Ultimately,
however, we felt that any benefits to be derived from adding additional
metrics to the primary formula were outweighed by the additional
complexity that introduction of those additional size parameters would
entail. We wish to make it clear, however, that we believe that
additional determinants based on other metrics of size may be
appropriate in the context of individual securities regulations. For
example, our own recommendations on internal control over financial
reporting contain metrics conditioning the availability of scaling
treatment on company annual revenues.
Commission Has a Long History of Scaling Regulation
Since federal securities regulation began in the 1930's, it has
been recognized that some companies and transactions are of
insufficient magnitude to warrant full federal regulation, or any
federal regulation at all. Smaller public companies primarily have been
subject to two securities statutes, the Securities Act and the Exchange
Act. The Securities Act, originally enacted to cover distributions of
securities, has from the beginning contained a ``small issue''
exemption in Section 3(b) \40\ that gives the SEC rulemaking authority
to exempt any securities issue up to a specified maximum amount. This
amount has grown in stages, from $100,000 in 1933 to $5 million since
late 1980.\41\ The Exchange Act originally was enacted to regulate
post-distribution trading in securities. It did so by requiring
registration by companies of classes of
[[Page 11097]]
their securities. At first, the Exchange Act required companies to
register only if their securities were traded on a national securities
exchange. This assured that smaller companies of insufficient size to
warrant exchange listing would not be subject to overly burdensome
federal securities regulation.
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\40\ 15 U.S.C. 77c(b).
\41\ Louis Loss & Joel Seligman, Fundamentals of Securities
Regulation 387 (2004). The Commission has adopted a number of
exemptive measures for small issuers pursuant to its authority under
Section 3(b), including Rules 504 and 505, Regulation A and the
original version of Rule 701.
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In 1964, Congress extended the reach of most of the Exchange Act's
public company provisions to cover companies whose securities trade
over-the-counter.\42\ Since all securities other than exchange-listed
securities technically trade ``over-the-counter,'' this expansion
required limiting the companies covered to avoid creating a burden on
issuers and the Commission that was ``unwarranted by the number of
investors protected, the size of companies affected, and other factors
bearing on the public interest.'' \43\ Congress wanted to ensure that
``the flow of reports and proxy statements [would] be manageable from
the regulatory standpoint and not disproportionately burdensome on
issuers in relation to the national public interest to be served.''
\44\ Accordingly, Congress chose to limit coverage to companies with a
class of equity security held of record by at least 500 persons and net
assets above $1 million.\45\ Over time, the standard set by Congress at
500 equity holders of record and $1 million in net assets required
adjustment to assure that the burdens placed on issuers and the
Commission were justified by the number of investors protected, the
size of companies affected, and other factors bearing on the public
interest, as originally intended by Congress. The Commission has raised
the minimum net asset level several times; it now stands at $10
million.\46\
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\42\ Securities Acts Amendments of 1964, Pub. L. No. 88-467, 78
Stat. 565 (adding Section 12(g), among other provisions, to the
Exchange Act).
\43\ S. Rep. No. 88-379, at 19 (1963).
\44\ Id.
\45\ 15 U.S.C. 78l(g).
\46\ 17 CFR 240.12g5-1.
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In 1992, the Commission adopted Regulation S-B,\47\ a major
initiative that allows companies qualifying as ``small business
issuers'' (currently, companies with revenues and a public float of
less than $25 million \48\) to use a set of abbreviated disclosure
rules scaled for smaller companies. In 2002, the Commission divided
public companies into two categories, ``accelerated filers'' and ``non-
accelerated filers,'' and in 2005 added a third category of ``large
accelerated filers,'' providing scaled securities regulation for these
three tiers of reporting companies.\49\ Non-accelerated filers are
fundamentally public companies with a public float below $75 million,
and large accelerated filers are public companies with a public float
of $700 million or more.\50\
Notwithstanding the benefits to which smaller business issuers and
non-accelerated filers are entitled under the Commission's current
rules, we believe significant changes to the federal securities
regulatory system for smaller public companies, such as those
recommended in this report, are required to assure that it is properly
scaled for smaller public companies. Our experience with smaller public
companies, as well as the testimony and written statements we received,
support this view. We believe that the problem of improper scaling for
smaller public companies has existed for many years, and that the
additional regulations imposed by the Sarbanes-Oxley Act only
exacerbated the problem and caused it to become more visible.
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\47\ 17 CFR 228.10 et seq.
\48\ 17 CFR 228.10(a)(1). ``Small business issuers'' must also
be U.S. or Canadian companies, not investment companies and not
majority owned subsidiaries of companies that are not small business
issuers.
\49\ See Acceleration of Periodic Report Filing Dates and
Disclosure Concerning Web site Access to Report, SEC Release No. 33-
8128 (Sept. 16, 2002) [67 FR 58480].
\50\ 17 CFR 240.12b-2. Both accelerated filers and large
accelerated filers must also have been reporting for at least 12
months, have filed at least one annual report and not be eligible to
use Forms 10-KSB and 10-QSB.
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Part III. Internal Control Over Financial Reporting
Introduction
From the earliest stages of its implementation, Sarbanes-Oxley Act
Section 404 has posed special challenges for smaller public companies.
To some extent, the problems smaller companies have in complying with
Section 404 are the problems of companies generally:
Lack of clear guidance;
An unfamiliar regulatory environment;
An unfriendly legal and enforcement atmosphere that
diminishes the use and acceptance of professional judgment because of
fears of second-guessing by regulators and the plaintiff's bar; \51\
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\51\ See Conference Panelists Discuss Earnings Guidance and
Accounting Issues, SEC Today (Feb. 14, 2006), at 2 (quoting Teresa
Iannaconi as stating that while she believes the PCAOB is sincere in
its attempt to bring greater efficiency to the audit process,
accounting firms are not ready to step back, because they have all
received deficiency letters, none of which say that the auditors
should be doing less rather than more).
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A focus on detailed control activities by auditors; and
The lack of sufficient resources and competencies in an
area in which companies and auditors have previously placed less
emphasis.
But because of their different operating structures, smaller public
companies have felt the effects of Section 404 in a manner different
from their larger counterparts. With more limited resources, fewer
internal personnel and less revenue with which to offset both
implementation costs and the disproportionate fixed costs of Section
404 compliance, these companies have been disproportionately subject to
the burdens associated with Section 404 compliance. Moreover, the
benefits of documenting,\52\ testing and certifying the adequacy of
internal controls, while of obvious importance for large multinational
corporations, are of less certain value for smaller public companies,
who rely to a greater degree on ``tone at the top'' and high-level
monitoring controls, which may be undocumented and untested, to
influence accurate financial reporting. The result is a cost/benefit
equation that, many believe, diminishes shareholder value, makes
smaller public companies less attractive as investment opportunities
and impedes their ability to compete.
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