SEC Study of SOX 404(b) and Issuers with Public Float Between $75 and $250 Million

By Cydney Posner

Section 989G(b) of Dodd-Frank requires the SEC to conduct a study to determine how it could reduce the burden of complying with SOX 404(b), the auditor attestation requirement for internal control over financial reporting (ICFR), for companies with market caps between $75 million and $250 million, while maintaining investor protections. The study must also consider whether any methods of reducing the compliance burden or a complete exemption from SOX 404(b) for companies in that range would encourage them to conduct IPOs in the U.S. The study is now publicly available.

The study suggested that companies in the population analyzed generally do not have unique characteristics that would provide sufficient reasons for differentiating them from accelerated filers as a whole, including with regard to SOX 404(b). In addition, the study did not show that the U.S. has lost to foreign markets IPOs for U.S.-based issuers that would likely be in the $75 to $250 million public float range post-IPO. In addition, issuers filing IPOs in that range were not likely to remain in that range for an extended period of time. Although the share of worldwide IPOs raising $75 to $250 million has declined for U.S. markets over the past five years, the study did not find any conclusive evidence linking the requirements of SOX 404(b) to IPO activity.

The study also noted that the SEC has previously taken action to mitigate the compliance burden for new public companies by not requiring the auditor attestation on ICFR for the IPO and the first annual report thereafter. In addition, reforms the SEC implemented in 2007 through the issuance of an interpretive release, as well as the adoption by the PCAOB of AS 5, did reduce the compliance burden and improved the implementation of SOX 404 for the group studied. The staff also considered public input, which apparently was not very helpful in terms of recommending techniques to reduce the burden (other than through complete exemption).

The study found the following:

• The costs of SOX 404(b) have declined since it was first implemented, particularly in response to the 2007 reforms;
• Investors generally view the auditor‘s attestation on ICFR as beneficial;
• Financial reporting is more reliable when the auditor is involved with ICFR assessments; and
• There is no conclusive evidence linking the requirements of SOX 404(b) to listing decisions of the studied range of issuers.

The staff made two recommendations as a result of the study:

• Maintain for accelerated filers the existing investor protections of SOX 404(b) that have been in place since 2004 for domestic issuers and 2007 for foreign private issuers. Dodd-Frank already exempted approximately 60% of reporting issuers from SOX 404(b), and the staff does not believe that there should be additional exemptions: there is "strong evidence that the auditor‘s role in auditing the effectiveness of ICFR improves the reliability of internal control disclosures and financial reporting overall and is useful to investors." There was no specific evidence that potential savings would justify the loss of investor protections, given that the auditor must perform procedures to evaluate internal controls even when not performing an integrated audit. In addition, although the evidence was inconclusive, it did not show that an exemption to issuers in the population studied would, by itself, encourage companies to conduct IPOs in the U.S. The reasons for conducting an IPO in any location are complex and individual, although cost and regulation are certainly factors. At Chairman Schapiro‘s request, the staff is reviewing several SEC rules outside of SOX 404(b) to develop ideas to reduce regulatory burdens on small business capital formation.
• Encourage activities that have potential to further improve both effectiveness and efficiency of SOX 404(b) implementation. The staff recommended that the PCAOB monitor its inspection results and publish observations, similar to those published in September 2009, on the performance of audits conducted in accordance with AS 5. These observations could assist auditors in performing top-down, risk-based audits and include the lessons from internal control deficiencies identified through PCAOB inspections. The staff believes that COSO‘s project to review and update its internal control framework, the most commonly used ICFR framework, "can contribute to effective and efficient audits by providing management and auditors with improved internal control guidance that reflects today‘s operating and regulatory environment and by allowing constituent groups to share information on improvements that can be made that enhance the ability to design, implement, and assess internal controls."

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