Recommendations of the SEC Advisory Committee on Smaller Public Companies

By: Cydney Posner

Yesterday, the SEC Advisory Committee on Smaller Public Companies voted to approve a number of preliminary recommendations with respect to possible changes in connection with the regulation of smaller public companies. Note that some of their proposals have already been adopted or proposed by the SEC, so the views of the committee do apparently have some influence.

Internal Controls

The Internal Controls subcommittee concluded that the current requirements of SOX 404 led to disproportionate costs and burdens relative to benefits for smaller companies, particularly because of the reduced reliance of smaller companies on internal process controls. In addition, in smaller companies, internal controls were viewed as much less effective in preventing fraud, primarily because of the ease with which management can override controls. In particular, the subcommittee noted that AS 2 was not field-tested, and the subcommittee strongly recommended that the SEC review AS 2 to ensure necessary clarity while avoiding over-auditing.

The Internal Controls subcommittee recommended the following:

• Exempt microcap companies (companies with market cap and revenues of less than $125 million) from the application of SOX 404, subject to compliance with certain corporate governance requirements.
• Exempt smaller public companies (market cap of less than $750 million and revenues of less than $250 million) from the external audit requirements of SOX 404; these companies would still need to comply with the management assessment requirements of SOX 404.
• If the exemptions above were not adopted, direct the PCAOB to develop an alternative standard to AS 2 for smaller public companies (called ASX) that focused on external audit of the design and implementation of internal controls, but not testing of their operating effectiveness, which standard would be subject of an advance cost/benefit analysis;
• Develop a new standard for the management assessment requirement of SOX 404 (because the AS 2/COSO standard is really an audit standard) and, in recognition that over-auditing comes at a price, request that the SEC and PCAOB provide greater clarity and assistance under the audit standard (although this is not a request to amend AS 2); and
• Minimize unintended consequences by treating special cases separately, such as debt-only companies (biotechs and IPOs were later mentioned also).

Corporate Governance and Disclosure

The Corporate Governance and Disclosure subcommittee recommended the following:

• Eliminate further acceleration of the due dates of annual and quarterly reports required under the Exchange Act beyond 75 days for annual reports and 40 days for quarterly reports. Adopted by the SEC on December 14, 2005.
• In the event the SEC elects to provide smaller public companies with relief under SOX 404, as a condition to that relief, require additional disclosure concerning the issuer’s internal controls (such as internal control resources available, type of oversight and identification of weakness or problems) and impose (or require prominent disclosure of) additional "corporate hygienics," including audit committee corporate governance standards, whether or not required under applicable SRO listing standards, substantially equivalent to those codified under Rule 10A-3 (audit committee independence, responsibility for selection and oversight of auditors, procedures for handling complaints, authority to engage independent advisors and funding).
• To provide foreign private issuers with greater certainty concerning the date for compliance with SOX 404, test status as of the end of an earlier fiscal period, such as of the end of the prior fiscal year.
• Amend SEC rules under Sections 12(g) and 15(d) of the Exchange Act as follows:
  • interpret "held of record" to mean beneficial holders,
  • increase the thresholds (with a substantial phase-in) requiring registration under the Exchange Act to $15 million in total assets and 1,000 securityholders
  • amend the deregistration threshold under Section 15(d) to change the threshold number of securityholders, and
  • exclude from the count of the number of securityholders holders of unexercised options issued in compensatory transactions.
• Provide greater clarity under SOX 402 as to the types of transactions that fall within the prohibition, including guidance on cashless exercises, indemnity advances, relocation accommodations and split-dollar life insurance policies. (The subcommittee viewed these transactions, if approved by independent directors, as unlikely to lead to the types of abuse that SOX 402 was intended to prohibit.)
• Reduce the costs associated with the preparation, filing and dissemination of SEC documents where such cost reductions can be achieved without compromising investor protection by:
• Reducing the annual financial statement requirements to require an audited balance sheet as of the end of the two most recent fiscal years and audited statements of income, cash flows and changes in stockholders' equity for each of the two fiscal years preceding the date of the most recent audited balance sheet, as well as corresponding changes to the MD&A;
• Reducing complexity by consolidating Reg S-B and Reg S-K and modifying S-K to make accommodations for smaller public companies;
• Eliminating the need to disseminate paper versions of SEC documents to investors by extending the "access equals delivery" presumption to all SEC filings available in electronic form over the internet, including all Exchange Act reports and documents, provided that issuers provide physical notice of the availability of the documents and agree to provide security holders with paper versions without charge upon request; Proposed by the SEC for proxy materials on November 29, 2005.
• Allowing smaller public companies to use Form S-3 and to incorporate past and future SEC filings by reference and eliminate the requirement of timely filing for the preceding 12 calendar months as a condition to use of Form S-3, provided that the issuer is current and has been reporting under the Exchange Act for at least 12 months. The subcommittee contended that an issuer’s failure to timely file an SEC report should not result in increased costs of compliance and duplication of information already widely available;
• Establishing a task force to reduce inefficiencies associated with 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; and
• Examining ways to further reduce costs associated with SEC filings, including technological alternatives to EDGAR.

The Accounting Standards subcommittee recommended the following:

• Microcap companies should be permitted to apply the same effective dates that the FASB provides for private companies in implementing new accounting standards.
• The SEC should implement a de minimis provision in the application of independence rules; currently, a minor independence problem can have very serious consequences.
• The SEC should consider additional guidance for all public companies with respect to materiality related to previously issued financial statements; any restatement, regardless of how material, usually has significant adverse consequences that may not be warranted under the circumstances.
• The SEC should change the requirements for smaller public companies, including microcap companies, from reporting three years of financial information to reporting two years of financial information.
• The SEC should formally encourage the FASB to pursue objectives-based accounting standards. In addition, simplicity and the ease of application should be important considerations when new accounting standards are established. This recommendation is one that the SEC has also been promoting recently.
• The SEC should 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.
• The SEC and the PCAOB should promote competition among audit firms by using their influence to include non-Big Four firms in committees, public forums, etc. that would increase market awareness of these firms. The PCAOB should also consider minimum annual continuing professional education requirements covering topics specific to SEC matters for firms that wish to practice before the SEC.
• The PCAOB should monitor the impact of its May 2005 guidance regarding the interaction between the auditor and its clients through the spring of 2006 reporting season. If the guidance is being appropriately applied, no further action would be recommended, except for the matter discussed in the second recommendation.
• The SEC should seek to strengthen COSO in light of its role in the standard-setting process in internal control reporting.
• The SEC should commit more resources and professional staff to an office of ombudsman or "help desk" to provide assistance to smaller public companies. The SEC should also publish guidance on reporting and legal requirements aimed at assisting smaller public companies.

The Capital Formation subcommittee recommended the following:

• Adopt a new private offering exemption that does not prohibit general solicitation and advertising for transactions with certain qualified purchasers. The exemption would require that sales be made only to "Eligible Purchasers" that satisfy requirements related to financial status, investment sophistication, relationship to the issuer or institutional status, similar to Reg D, but with higher thresholds for suitability. The securities should be sold under NSMIA and should be subject to a two-way integration safe harbor similar to that included in Rule 701. Offers and sales made in compliance with the new exemption should generally not be subject to integration. With respect to the general solicitation aspect, the SEC could adopt antifraud safe harbor disclosure guidelines similar to the existing "tombstone" rules that would be applicable to the new exemption for communications utilizing Internet, television, radio, newspapers and other mass media.
• Spearhead a multi-agency effort to create a streamlined NASD registration process for finders, M&A advisors and institutional private placement practitioners substantially in accordance with the ABA Task Force proposal reported in The Business Lawyer. The purpose would be to eliminate the unregulated underground "money-finding" community that services companies unable to attract the attention of registered broker dealers, venture capitalists or traditional angel investors. A regulatory amnesty program is also recommended.
• Relax prohibitions against general solicitation and advertising, including a rule parallel to the "test the waters" model of Rule 254. The exemption should also take advantage of the "covered securities" exemption under NSMIA. In addition, the committee recommended that the SEC:
  • amend the language of the Rule 152 integration safe harbor to permit a registered public offering to commence immediately after the completion of an otherwise valid private offering, where the stated purpose was to raise capital to fund the IPO process;
  • shorten the integration safe harbor period from the current six months (to 30 or 45 days) and
  • amend the definition of "qualified purchaser" as permitted under NSMIA.
• Make it easier for the smallest public companies to go private (i.e., the lowest 1% of total market capitalization), subject to the issuer's undertaking to provide 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.
• The SEC should work in conjunction with the NASD to ensure viable trading markets for smaller public companies and amend rules and practices that inhibit the efficient functioning of certain markets. The committee contended that the Pink Sheets market and the OTCBB market, owned by the NASD and run on a contractual basis by Nasdaq, could benefit from the following:
  • Make public information filed under Rule 15c2-11;
  • Make available Form S-3 for OTCBB securities in resale transactions;
  • Make Nasdaq SmallCap stocks and/or OTCBB-listed stocks "covered securities" under NSMIA to exempt them from state review, contingent on compliance with corporate governance requirements; and
  • Increase the size of companies defined by the SEC as "Small Business Issuers" to the microcap company level.
• The committee suggested that the costs of maintaining the OTCBB be shared by the companies that benefit from it and, similarly, that corporate support for the Pink Sheets market be derived from direct corporate payments to dealers for market-making activity. The subcommittee believes this approach will encourage more entry of dealers into market-making activities.
• The SEC should adopt policies that encourage and promote the dissemination of research on smaller public companies by, among other things, allowing company-sponsored research to occur with full disclosure by the research provider as to the nature of the relationship with the company being covered and maintaining soft dollar payments for research under current safe harbor provisions of Rule 28e. New business models that rely on corporate payments to create published research should be permitted.
• The SEC should adopt the following amendments to Rule 701:
  • Increase from $5 million to $10 million the amount of sales under the rule necessary to trigger financial statement and risk factor disclosures; and
  • As an alternative, eliminate or significantly modify financial statement disclosure requirements if options are non-transferable except by law and if options may be exercised only on a "net" basis with no employee funds paid to the employer.
• Provide relief from the Exchange Act registration requirements that treat employee stock options as voting securities without regard as to whether the options are currently exercisable. PIPE transaction relief may be the subject of future recommendations.