SEC Advisory Committee on Smaller Public Companies adopts final recommendations

By:  Cydney Posner

This morning, at its last meeting, the SEC Advisory Committee on Smaller Public Companies voted to submit its  final recommendations and report to the SEC. No significant changes were discussed. John White, the SEC's new director of corp fin, opened the meeting by emphasizing that the Committee's recommendations would be received with an open mind. Once again, the principal debate centered around SOX 404, with three members dissenting to most of the 404 proposals. One of the Committee's three dissenters on the SOX 404 recommendations argued that he was concerned that the recommendations had been adopted in haste and presented only a quick fix to a complex problem and that the committee was forsaking investor protection with respect to this hallmark of SOX. Other members countered that SOX 404 was not the hallmark of SOX, but rather that the board independence, audit committee requirements and "tone-at-the-top" provisions had had much greater positive impact. Indeed, they expressed concern that SOX 404 gave investors a false sense of security, because 404 was unlikely to prevent intentional fraudulent schemes like Enron. These members also contended that it was SOX, not the Committee's recommendations, that had been adopted in haste. Some members were even more contentious, denouncing the orchestrated attacks that seem to have appeared in the news prior to each meeting and rejecting the notion that there were insufficient investor advocates on the Committee. (All but one of the self-styled investor advocates on the Committee agreed with all of the recommendations.) On the other hand, some members were anxious to point out that, even with respect to SOX 404, there were substantial areas of agreement on the Committee and, that everyone agreed that the costs of SOX 404 were too high for smaller companies. Moreover, they argued that the key SOX 404 recommendations had been mischaracterized as providing exemptions for some small companies, while they really sought to achieve a "staged implementation" in exchange for the acceptance of specified governance standards. (See my postings of 4/19/06, 4/12/06, 4/10/06, 4/4/06, 3/20/06, 3/2/06, 2/22/06, 2/21/06,12/15/05, 9/21/05, 9/14/05, 8,10/06, 8/2/05, 4/27/05 and 12/16/04.)

Below is a summary of the committee's recommendations:

• Establish a new system of scaled, self-calibrating regulation that would divide smaller public companies into two groups, microcap companies and smallcap companies, using a number of determinants, such as market cap. Under this recommendation, microcap companies would consist of companies with the lowest 1% of total U.S. equity market capitalization, and smallcap companies would consist of companies with the next lowest 5% of total U.S. equity market capitalization. The table below illustrates the crux of the battle: while small public companies account for only a small percentage of total U.S. equity market capitalization, these companies represent a substantial percentage of the number of U.S. public companies

• Unless and until a framework for assessing internal control over financial reporting for small public companies is developed that recognizes their characteristics and needs, provide exemptive relief from the SOX 404 to microcap companies with less than $125 million in annual revenue and to smallcap companies with less than $10 million in product revenue, that have or add corporate governance controls that include:
  • adherence to standards relating to audit committees in conformity with Rule 10A-3; and
  • adoption of a code of ethics within the meaning of Item 406 of Reg S-K applicable to all directors, officers and employees and disclosure of the code in connection of the company’s obligations under Item 406(c) relating to the disclosure of codes of ethics.

In addition, the SEC should confirm, and if necessary clarify, the application to all microcap and smallcap companies 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 and their material consequences, apply CEO and CFO certifications to these disclosures and have their managements report on any known material weaknesses.

• Unless and until a framework for small public companies is developed as described above, provide exemptive relief from external auditor involvement in the SOX 404 process to the following companies, subject to their compliance with the same corporate governance standards as detailed in the recommendation immediately above:
  • 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.

The table below shows the number and percentage of public companies eligible for relief under these two recommendations:

The Committee concluded that, under these recommendations, approximately 95%, or $16,046 billion, of the total U.S. equity market capitalization of $16,891 billion, would remain fully subject to SOX 404. Companies accounting for the remaining 5%, or $845 billion, would be eligible for relief unless and until an appropriate framework was developed. Note, however, that this 5% represents approximately 70% of public companies.