Notice: Meetings: Securities and Regulatory Issues For Smaller Companies Smaller Public Companies Advisory Committee Final Report

Friday,
March 3, 2006
Part IV
Securities and
Exchange
Commission
Advisory Committee on Smaller Public
Companies; Notice
rwilkins on PROD1PC63 with NOTICES3
VerDate Aug<31>2005 16:52 Mar 02, 2006 Jkt 205001 PO 00000 Frm 00001 Fmt 4717 Sfmt 4717 E:\FR\FM\03MRN3.SGM 03MRN3
11090 Federal Register / Vol. 71, No. 42 / Friday, March 3, 2006 / Notices
SECURITIES AND EXCHANGE 3260, Office of Small Business Policy, *Access to each appendix is available by
COMMISSION Division of Corporation Finance, clicking its name on the copy of this page
Securities and Exchange Commission, posted on the Internet at http://www.sec.gov/
[Release Nos. 33–8666; 34–53385; File No. info/smallbus/acscp-finalreport_ed.pdf.
265–23]
100 F Street, NE., Washington, DC
20549–3628. Transmittal Letter—SEC Advisory
SUPPLEMENTARY INFORMATION: The SEC Committee on Smaller Public Companies
Exposure Draft of Final Report of
Advisory Committee on Smaller Public Advisory Committee on Smaller Public Washington, DC 20549–3628.
Companies Companies is publishing an exposure [April 23], 2006
draft of its Final Report to solicit public The Honorable Christopher Cox, Chairman,
AGENCY: Securities and Exchange comment on the draft. The draft
Commission. U.S. Securities and Exchange Commission,
contains proposed recommendations of 100 F Street, NE, Washington, DC 20549–
ACTION: Publication of Exposure Draft of the Committee on improving the current 1070.
Advisory Committee Final Report, securities regulatory system for smaller Dear Chairman Cox: On behalf of the
Request for Public Comment. companies. All interested parties are Commission’s Advisory Committee on
invited to submit their comments in the Smaller Public Companies, we are pleased to
SUMMARY: The Securities and Exchange submit our Final Report.
manner described above. The Advisory
Commission Advisory Committee on Committee is especially interested in [Contents of letter to be included in Final
Smaller Public Companies is publishing receiving comments from investors in Report.]
an exposure draft of its Final Report and microcap and smallcap companies, as Respectfully submitted on behalf of the
requesting public comment on it. well as from their managements. The Committee.
DATES: Comments should be received on draft has been approved as an exposure Herbert S. Wander,
or before April 3, 2006. draft by the Advisory Committee. It does Committee Co-Chair.
ADDRESSES: Comments may be not necessarily reflect any position or James C. Thyen,
submitted by any of the following regulatory agenda of the Commission or Committee Co-Chair.
methods: its staff. Enclosure
The text of the exposure draft follows: cc: Commissioner Cynthia A. Glassman
Electronic Statements
Final Report of the Advisory Committee Commissioner Paul S. Atkins
• Use the Commission’s Internet Commissioner Roel C. Campos
submission form (http://www.sec.gov/ on Smaller Public Companies to the Commissioner Annette L. Nazareth; Ms.
info/smallbus/acspc.shtml); or U.S. Securities and Exchange Nancy M. Morris
• Send an e-mail message to rule- Commission
Members, Official Observers and Staff
comments@sec.gov. Please include File [April 23], 2006 of Advisory Committee
Number 265–23 on the subject line; or Table of Contents Members
Paper Comments Transmittal Letter
Members, Official Observers and Staff of
Herbert S. Wander, Co-Chair, Partner,
• Send paper comments in triplicate Katten Muchin Zavis Rosenman (Ex
Advisory Committee
to Nancy M. Morris, Federal Advisory Part I. Committee History Officio Member of All Subcommittees
Committee Management Officer, Part II. Scaling Securities Regulation for and Size Task Force)
Securities and Exchange Commission, Smaller Companies James C. Thyen, Co-Chair, President and
100 F Street, NE., Washington, DC Part III. Internal Control Over Financial CEO, Kimball International, Inc. (Ex
20549–1090. You may also fax your Reporting Officio Member of All Subcommittees,
submission to 202–772–9324, Attn: Part IV. Capital Formation, Corporate Chairperson of Size Task Force)
Federal Advisory Committee Governance and Disclosure Patrick C. Barry, Chief Financial Officer
Part V. Accounting Standards
Management Officer. and Chief Operating Officer, Bluefly,
Part VI. Epilogue
All submissions should refer to File No. Part VII. Separate Statement of Mr. Jensen Inc. (Accounting Standards
265–23. This file number should be Part VIII. Separate Statement of Mr. Schacht Subcommittee, Size Task Force)
included on the subject line if e-mail is Part IX. Separate Statement of Mr. Veihmeyer Steven E. Bochner, Partner, Wilson
used. To help us process and review Appendices* Sonsini Goodrich & Rosati,
your comments more efficiently, please A. Official Notice of Establishment of Professional Corporation
Committee (Chairperson, Corporate Governance
use only one method. The Commission B. Committee Charter
will post all comments on its Web site and Disclosure Subcommittee)
C. Committee Agenda Richard D. Brounstein, Executive Vice
(http://www.sec.gov./info/smallbus/ D. SEC Press Release Announcing Intent President and Chief Financial Officer,
acspc.shtml). To Establish Committee
Calypte Biomedical Corp. (Internal
Comments also will be available for E. SEC Press Release Announcing Full
Membership of Committee Control Over Financial Reporting
public inspection and copying in the
F. Committee By-Laws Subcommittee)
Commission’s Public Reference Room, C.R. ‘‘Rusty’’ Cloutier, President and
100 F Street, NE., Washington, DC G. Request for Public Comments on
Committee Agenda Chief Executive Officer, MidSouth
20549. All comments received will be H. Request for Public Input Bancorp, Inc. (Corporate Governance
posted without change; we do not edit I. Background Statistics for All Public and Disclosure Subcommittee)
personal identifying information from Companies James A. ‘‘Drew’’ Connolly III,
submissions. You should submit only J. Universe of Publicly Traded Equity President, IBA Capital Funding
information that you wish to make Securities and Their Governance (Capital Formation Subcommittee)
available publicly. K. List of Witnesses
E. David Coolidge III, Vice Chairman,

L. Letter from Committee Co-Chairs to SEC
FOR FURTHER INFORMATION CONTACT: William Blair & Company
Chairman Christopher Cox dated August
Questions about this release should be 18, 2005 (Chairperson, Capital Formation
referred to William A. Hines, Special M. SEC Statement of Policy on Accounting Subcommittee)
Counsel, at (202) 551–3320, or Kevin M. Provisions of Foreign Corrupt Practices Alex Davern, Chief Financial Officer
O’Neill, Special Counsel, at (202) 551– Act and Senior Vice President of
Federal Register / Vol. 71, No. 42 / Friday, March 3, 2006 / Notices 11091
Manufacturing and Information Mauri L. Osheroff, Associate Director securities laws of the United States, and
Technology Operations, National (Regulatory Policy), Division of make recommendations for changes.
Instruments Corp. (Internal Control Corporation Finance The Charter also directed that we
Over Financial Reporting Gerald J. Laporte, Committee Staff specifically consider the following areas
Subcommittee, Size Task Force) Director Chief, Office of Small of inquiry, including the impact in each
Joseph ‘‘Leroy’’ Dennis, Executive Business Policy, Division of area of the Sarbanes-Oxley Act of 2002: 2
Partner, McGladrey & Pullen Corporation Finance • Frameworks for internal control
(Chairperson, Accounting Standards Kevin M. O’Neill, Committee Deputy over financial reporting applicable to
Subcommittee) Staff Director, Special Counsel, Office smaller public companies, methods for
Janet Dolan, Former Chief Executive of Small Business Policy, Division of management’s assessment of such
Officer, Tennant Company Corporation Finance internal control, and standards for
(Chairperson, Internal Control Over Cindy Alexander, Assistant Chief auditing such internal control;
Financial Reporting Subcommittee) Economist, Corporate Finance and • Corporate disclosure and reporting
Richard M. Jaffee, Chairman of the Disclosure, Office of Economic requirements and federally imposed
Board, Oil-Dri Corporation of America Analysis corporate governance requirements for
(Corporate Governance and Disclosure Anthony G. Barone, Special Counsel, smaller public companies, including
Subcommittee, Size Task Force) Office of Small Business Policy, differing regulatory requirements based
Mark Jensen, National Director, Venture Division of Corporation Finance on market capitalization, other
Capital Services, Deloitte & Touche Jennifer Burns, Public Accounting measurements of size or market
(Internal Control Over Financial Fellow, Office of the Chief characteristics;
Reporting Subcommittee)
Deborah D. Lambert, Co-Founder,
Accountant • Accounting standards and financial
Mark W. Green, Senior Special Counsel, reporting requirements applicable to
Johnson Lambert & Co. (Internal Division of Corporation Finance
Control Over Financial Reporting smaller public companies; and
Kathleen Weiss Hanley, Economic • The process, requirements and
Subcommittee) Fellow, Office of Economic Analysis
Richard M. Leisner, Partner, Trenam exemptions relating to offerings of
William A. Hines, Special Counsel, securities by smaller companies,
Kemker (Capital Formation
Office of Small Business Policy, particularly public offerings.
Subcommittee, Size Task Force)
Division of Corporation Finance The Charter further directed us to
Robert E. Robotti, President and
Alison Spivey, Associate Chief conduct our work with a view to
Managing Director, Robotti &
Accountant, Office of the Chief furthering the Commission’s investor
Company, LLC (Corporate Governance
Accountant protection mandate, and to consider
and Disclosure Subcommittee)
Scott R. Royster, Executive Vice Executive Summary 1 whether the costs imposed by the
President & Chief Financial Officer, current regulatory system for smaller
Radio One, Inc. (Capital Formation Background companies are proportionate to the
Subcommittee) The U.S. Securities and Exchange benefits, identify methods of
Pastora San Juan Cafferty, Professor, Commission (the ‘‘Commission’’ or minimizing costs and maximizing
School of Social Service ‘‘SEC’’) chartered the Advisory benefits and facilitate capital formation
Administration, University of Chicago Committee on Smaller Public by smaller companies. The language of
(Corporate Governance and Disclosure Companies on March 23, 2005. The our Charter specified that we should
Subcommittee) Charter provided that our objective was consider providing recommendations as
Kurt Schacht, Executive Director, CFA to assess the current regulatory system to where and how the Commission
Centre for Financial Market Integrity for smaller companies under the should draw lines to scale regulatory
(Internal Control Over Financial treatment for companies based on size.
Reporting Subcommittee) 1 This report has been approved by the Committee Our chartering documents 3 purposely
Ted Schlein, Managing Partner, Kleiner and reflects the views of a majority of its members. did not define the phrase ‘‘smaller
Perkins Caufield & Byers (Capital It does not necessarily reflect any position or public company.’’ Rather, it was
regulatory agenda of the Commission or its staff.
Formation Subcommittee) intended that we recommend how the
Note on Terminology: To aid understanding and
John B. Veihmeyer, Deputy Chairman, improve readability, we have tried to avoid using term should be defined. In addition, we
KPMG LLP (Accounting Standards defined terms with initial capital letters in this were advised that we were charged with
Subcommittee) report. We generally use the terms ‘‘public assessing the securities regulatory
company’’ and ‘‘reporting company’’
Official Observers interchangeably to refer to any company that is
system for all smaller companies, both
required to file annual and quarterly reports with public and private, and were not limited
George J. Batavick, Member, Financial the SEC in accordance with either Section 13 or to considering regulations applicable to
Accounting Standards Board (FASB) 15(d) of the Securities Exchange Act of 1934, 15 public companies. The Commissioners
(Accounting Standards U.S.C. 78m or 78o(d). When we refer to ‘‘microcap
and the SEC staff did advise us,
Subcommittee) companies,’’ we are referring to public companies
with equity capitalizations of approximately $128 however, that they hoped we would
Daniel L. Goelzer, Member, Public million or less. When we discuss ‘‘smallcap focus primarily on public companies,
Company Accounting Oversight companies,’’ we are talking about public companies because of the apparent need for prompt
Board (Internal Control Over with equity capitalizations of approximately $128
attention to that area of concern,
Financial Reporting Subcommittee) million to $787 million. We believe these labels
generally are consistent with securities industry especially in view of problems in
Jack E. Herstein, Assistant Director,
custom and usage. When we refer to ‘‘smaller implementing the Sarbanes-Oxley Act of
Nebraska Bureau of Securities (Capital public companies,’’ we are referring to public 2002.
Formation Subcommittee) companies with equity capitalizations of
approximately $787 million and less, which

SEC Staff includes both microcap and smallcap companies. 2 Pub. L. No. 107–204, 116 Stat. 745 (July 30,
We recognize that formal legal definitions of these 2002).

Alan L. Beller, Director (until February
terms may be necessary to implement some of our 3 The official notice of establishment of the
2006) Division of Corporation Finance recommendations that use them, and we discuss Committee and its Charter, included in this report
Martin P. Dunn, Deputy Director, our recommendations as to how some of them as Appendices A and B, respectively, constitute our
Division of Corporation Finance should be defined in Part II. chartering documents.
Our 21 members voted unanimously final recommendations contained in this Before addressing our
on April 20, 2006 to adopt this Final report.4 recommendations, the Committee
Report and transmit it to the We recognize that it is unlikely that wishes to emphasize that each of our
Commission. The recommendations set the Commission and its staff will be able members fully embraces the concepts of
forth in this report were for the most to consider, much less act upon, all 32 good governance and transparency. We
part adopted unanimously. Where one of these recommendations at once. believe our recommendations are
or more members dissented or, while Furthermore, submitting such a large designed to further these goals while
present, abstained from voting with number of recommendations, without establishing cost effective methods of
respect to a specific recommendation, any indication of the importance or
achieving them.
that fact has been noted in the text. priority we ascribe to them, might make
the Commission less likely to act upon Our first primary recommendation
Additionally, Parts VII, VIII and IX of
this report contains separate statements recommendations in areas where we concerns establishment of a new system
submitted by Mark Jensen, Kurt Schacht believe the need for action is most of scaled or proportional securities
and John B. Veihmeyer that describe urgent. Accordingly, we have adopted a regulation for smaller public companies
briefly their reasons for disagreeing with two-tiered approach towards the based on a stratification of smaller
specific recommendations of the prioritization of our recommendations. public companies into two groups,
The first tier—the recommendations microcap companies and smallcap
majority of our voting members.
to which we assign the highest companies. Under this
Recommendations priority—we refer to as our ‘‘primary recommendation, microcap companies
recommendations.’’ Our primary would consist of companies whose
Our final recommendations are recommendations are set forth under the outstanding common stock (or
discussed in the remainder of this specific topic to which they relate: Our equivalent) in the aggregate comprises
report. Before summarizing our highest recommendation concerning the lowest 1% of total U.S. equity
priority recommendations below, we establishment of a scaled securities
would like to explain why we have market capitalization, and smallcap
regulation system is discussed under the
presented them in the order that we companies would consist of companies
caption ‘‘Part II. Scaling Securities
have. As detailed under the caption whose outstanding common stock (or
Regulation for Smaller Companies’’;
‘‘Part I—Committee History—Committee equivalent) in the aggregate comprises
recommendations related to internal
Activities,’’ we conducted most of our control over financial reporting are the next lowest 5% of total U.S. equity
preliminary deliberations in four discussed under the caption ‘‘Part III. market capitalization. Smaller public
subcommittees, and a ‘‘size task force’’ Internal Control Over Financial companies, consisting of microcap and
comprised of a representative of each Reporting’’; capital formation, corporate smallcap companies, would thus in the
subcommittee and Committee Co-Chair governance and disclosure aggregate comprise the lowest 6% of
James C. Thyen, who chaired the size recommendations are discussed under total U.S. equity market capitalization.
task force. The subcommittees and the the caption ‘‘Part IV. Capital Formation, While they account for only a small
size task force generated preliminary Corporate Governance and Disclosure’’; percentage of total U.S. equity market
recommendations that were discussed and accounting standards capitalization, these companies
and approved by the full Committee. We recommendations are discussed under represent a substantial percentage of all
agreed at our meeting on April 20, 2006 the caption ‘‘Part V. Accounting U.S. public companies, as shown in the
to submit to the Commission the 32 Standards.’’ table below:
Percentage of
Market capital- Percentage of all
total U.S. equity
ization cutoff U.S. public
market
(million) companies
capitalization
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 in-
clude 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 compa-
nies understates the percentage of U.S. public companies represented by microcap companies. See Appendix J.
We believe that the Commission treatment under the new system. about implementing in this approach
should establish this scaled system Because of its significance, we felt that ‘‘Part II. Scaling Securities Regulation
before or in connection with proceeding this recommendation merited for Smaller Companies.’’
to examine individual securities discussion under a separate caption. Below is a list of our remaining
regulations to determine whether they Accordingly, we discuss this primary recommendations, and the
are candidates for integration of scaling recommendation and our thoughts
4 This does not include two recommendations, The Commission acted favorably upon these two on Internal Over Financial Reporting and
which the Committee adopted on August 10, 2005 recommendations in September 2005. See Revisions Certification of Disclosure in Exchange Act Reports
and submitted to the Commission in a separate to Accelerated Filer Definition and Accelerated of Companies that are Not Accelerated Filers, SEC
report dated August 18, 2005 (included as Deadlines for Filing Periodic Reports, SEC Release Release No. 33–8618 (Sept. 22, 2005).
Appendix L of this report and discussed therein). No. 33–8617 (Sept. 22, 2005); Management’s Report
location in this report where they are relating to the disclosure of the code of available to all microcap companies,
described in greater detail: 5 ethics. and cease prescribing separate
• Establish a new system of scaled or In addition, as part of this specialized disclosure forms for smaller
proportional securities regulation for recommendation, we recommend that companies (Recommendation IV.P.1).
smaller public companies using the the Commission confirm, and if • Incorporate the primary scaled
following six determinants to define a necessary clarify, the application to all financial statement accommodations
‘‘smaller public company’’: microcap companies, and indeed to all currently available to small business
■ The total market capitalization of smallcap companies also, the existing issuers under Regulation S–B into
the company; general legal requirements regarding Regulation S–K or Regulation S–X and
■ A measurement metric that internal controls, including the make them available to all microcap and
facilitates scaling of regulation; requirement that companies maintain a smallcap companies (Recommendation
■ A measurement metric that is self- system of effective internal control over IV.P.2).
calibrating; financial reporting, disclose • Allow all reporting companies
modifications to internal control over listed on a national securities exchange,
■ A standardized measurement and
financial reporting and their material NASDAQ or the OTC Bulletin Board to
methodology for computing market
consequences, and apply CEO and CFO be eligible to use Form S–3, if they have
capitalization;
certifications to such disclosures. been reporting under the Exchange Act
■ A date for determining total market Moreover, management should be for at least one year and are current in
capitalization; and required to report on any known their reporting at the time of filing
■ Clear and firm transition rules, i.e., material weaknesses. In this regard, the (Recommendation IV.P.3).
small to large and large to small Proposed Statement on Auditing • Adopt policies that encourage and
(Recommendation II.P.1). Standards of the AICPA, promote the dissemination of research
Develop specific scaled or ‘‘Communications of Internal Control on smaller public companies
proportional regulation for companies Related Matters Noted in an Audit,’’ if (Recommendation IV.P.4).
under the system if they qualify as adopted by the AICPA and the Public • Adopt a new private offering
‘‘microcap companies’’ because their Company Accounting Oversight Board exemption from the registration
equity market capitalization places them (PCAOB), would strengthen this requirements of the Securities Act of
in the lowest 1% of total U.S. equity disclosure requirement and provide 1933 (the ‘‘Securities Act’’) 9 that does
market capitalization or as ‘‘smallcap some external auditor involvement in not prohibit general solicitation and
companies’’ because their equity market the internal control over financial advertising for transactions with
capitalization places them in the next reporting process. (Recommendation purchasers who do not need all the
lowest 1% to 5% of total U.S. equity III.P.1). protections of the Securities Act’s
market capitalization, with the result • Unless and until a framework for registration requirements. Additionally,
that all companies comprising the assessing internal control over financial relax prohibitions against general
lowest 6% would be considered for reporting for smallcap companies is solicitation and advertising found in
scaled or proportional regulation. developed that recognizes the Rule 502(c) under the Securities Act to
• Unless and until a framework for characteristics and needs of those parallel the ‘‘test the waters’’ model of
assessing internal control over financial companies, provide exemptive relief Rule 254 under that Act
reporting for microcap companies is from external auditor involvement in (Recommendation IV.P.5).
developed that recognizes the the Section 404 process to smallcap • Spearhead a multi-agency effort to
characteristics and needs of those companies with less than $250 million create a streamlined NASD registration
companies, provide exemptive relief but greater than $10 million in annual process for finders, M&A advisors and
from the requirements of Section 404 of product revenues, subject to their institutional private placement
the Sarbanes-Oxley Act 6 to microcap compliance with the same corporate practitioners (Recommendation IV.P.6).
companies with less than $125 million governance standards detailed in the • Develop a ‘‘safe-harbor’’ protocol
in annual revenue and to smallcap recommendation above for accounting for transactions that
companies with less than $10 million in (Recommendation III.P.2). would protect well-intentioned
annual product revenue that have or • While we believe that the costs of preparers from regulatory or legal action
expand their corporate governance the requirement for an external audit of when the process is appropriately
controls to include: the effectiveness of internal control over followed (Recommendation V.P.1).
■ Adherence to standards relating to financial reporting are disproportionate • In implementing new accounting
audit committees in conformity with to the benefits, and have therefore standards, the FASB should permit
Rule 10A–3 under the Securities adopted the second Section 404 microcap companies to apply the same
Exchange Act of 1934; 7 and recommendation above, we also believe extended effective dates that it provides
• Adoption of a code of ethics within that if the Commission reaches a public for private companies (Recommendation
the meaning of Item 406 of Regulation policy conclusion that an audit V.P.2).
S–K 8 applicable to all directors, officers requirement is required, we recommend • Consider additional guidance for all
and employees and compliance with the that changes be made to the public companies with respect to
further obligations under Item 406(c) requirements for implementing Section materiality related to previously issued
404’s external auditor requirement to a financial statements (Recommendation
5 We have labeled our recommendations by
cost-effective standard, which we call V.P.3).
section in which their full description appears, ‘‘ASX,’’ providing for an external audit • Implement a de minimis provision
status (either primary (P) or secondary (S)), and of the design and implementation of in the application of the SEC’s auditor
rank within a given section. Hence the first primary
internal controls (Recommendation independence rules (Recommendation

recommendation in Part III is Recommendation
III.P.1; the third secondary recommendation in Part
III.P.3). V.P.4).
IV is Recommendation IV.S.3, etc. • Incorporate the scaled disclosure Our second tier consists of all of the
6 15 U.S.C. 7262. accommodations currently available to remaining recommendations, which we
7 15 U.S.C. 78a et seq. small business issuers under Regulation
8 17 CFR 229. S–B into Regulation S–K, make them 9 15 U.S.C. 77a et seq.
refer to in this report as ‘‘secondary proposed a Committee Agenda to be August 3, 2005, addressed us at the
recommendations.’’ Although we have published for public comment 14 and October 24 meeting in Washington. No
assigned these a lower priority than the reviewed a subcommittee structure and witnesses testified at the additional
recommendations set forth above, we do Master Schedule prepared by our Co- meetings in Washington.
not in any way intend to diminish their Chairs. This and all of our subsequent The Committee, through the
importance. In this regard, we note that meetings were open to the public and Commission, published three releases in
importance is at times not only a conducted in accordance with the the Federal Register formally seeking
function of the perceived need for requirements of the Federal Advisory public comment on issues it was
change but also the perceived ease with Committee Act.15 All meetings of the considering. On April 29, 2005, we
which the Commission could enact such full Committee also were Web cast over published a release seeking comments
change; as noted throughout the report, the Internet. on our proposed Committee Agenda,19
many problems simply defy easy Shortly following our formation, we in response to which we received ll
solution. Moreover, several of these adopted several overarching principles written submissions. On August 2, 2005,
recommendations are aspirational in to guide our efforts: we published 29 questions on which we
nature, and do not involve specific • Further Commission’s investor sought public input, to which we
Commission action. As with the primary protection mandate. received 266 responses.20 Finally, on
recommendations, these secondary • Seek cost choice/benefit inputs. llllll, 2006, we published an
recommendations are set forth under the • Keep it simple. exposure draft of our final report,21
specific topics to which they relate, and • Maintain culture of which generated ll written
within each such section, entrepreneurship. submissions. In addition, each meeting
recommendations are presented in • Capital formation should be of the Committee was announced by
descending order of importance (i.e., the encouraged. formal notice in a Federal Register
• Recommendations should be release, and each such notice included
secondary recommendation that we
prioritized. an invitation to submit written
would most like to see adopted is listed We held subsequent meetings in 2005
first, etc.). statements to be considered in
on June 16 and 17 in New York City, connection with the meeting. In total,
Part I. Committee History August 9 and 10 in Chicago, September we received ll written statements in
19 and 20 in San Francisco, and October response to Federal Register releases.22
On December 16, 2004, then SEC
14 again in New York City. A total of 42 In addition to work carried out by the
Chairman William H. Donaldson
witnesses testified at these meetings.16 full Committee, fact finding and
announced the Commission’s intent to
establish the SEC Advisory Committee We adopted our Committee Agenda at deliberations also took place within four
on Smaller Public Companies.10 At the the June 16 meeting in New York.17 We subcommittees appointed by our Co-
adopted two recommendations to the Chairs. The subcommittees were
same time, Chairman Donaldson
Commission at our Chicago meeting, organized according to their principal
announced his intention to name
where we also adopted an internal areas of focus: Accounting Standards,
Herbert S. Wander and James C. Thyen
working definition of the term ‘‘smaller Capital Formation, Corporate
as Co-Chairs of the Committee. The
public company.’’ 18 We held additional Governance and Disclosure, and
official notice of our establishment was
published in the Federal Register five meetings in Washington on October 24 Internal Control Over Financial
days later.11 The Committee’s and 25 and December 14, 2005 and Reporting. Each of the subcommittees
February 21, 2006 to consider and vote prepared recommendations for
membership was completed on March 7,
on recommendations and the draft of consideration by the full Committee. We
2005, with members drawn from a wide
our final report to the Commission. SEC approved preliminary versions of most
range of professions, backgrounds and
Chairman Christopher Cox, who had recommendations at our December 14,
experiences.12 The Committee’s Charter
succeeded Chairman Donaldson on 2005 meeting. A fifth subgroup,
was filed with the Senate Committee on
Banking, Housing and Urban Affairs and sometimes referred to as the ‘‘size task
14 The Record of Proceedings of this and
the House Committee on Financial force’’ in our deliberations, consisted of
subsequent meetings of the Committee are available
Services on March 23, 2005, initiating on our Web site at http://www.sec.gov/info/
one volunteer from each subcommittee
our 13-month existence.13 smallbus/ascpc.shtml. See Record of Proceedings, and our Co-Chair James C. Thyen. The
Meeting of the Securities and Exchange size task force met to consider common
Committee Activities Commission Advisory Committee on Smaller Public issues faced by the subcommittees
Companies (Apr. 12, June 16, June 17, Aug. 9, Aug.
We held our organizational meeting 10, Sept. 19, Sept. 20, Oct. 24, Oct. 25 & Dec. 14,
relating to establishment of parameters
on April 12, 2005 in Washington, DC, 2005 & Feb. 21, Apr. 11 & Apr. 20, 2006) (on file for eventual recommendations on
where Chairman Donaldson swore in in SEC Public Reference Room File No. 265–23),
available at http://www.sec.gov/info/smallbus/ 19 Summary of Proposed Committee Agenda of
and addressed our members. Also at ascpc.shtml (hereinafter Record of Proceedings Advisory Committee on Smaller Public Companies,
that meeting, we adopted our by-laws, (with appropriate date)). SEC Release No. 33–8571, (Apr. 29, 2005) [70 FR
15 5 U.S.C.—App. 1 et seq. 22378].
10 SEC Establishes Advisory Committee to 16 Appendix K contains a list of witnesses who 20 See Request for Public Input by Advisory
Examine Impact of Sarbanes-Oxley Act on Smaller testified before the Committee. Committee on Smaller Public Companies, SEC
Public Companies, SEC Press Release No. 2004–174 17 The Committee Agenda is included as Release No. 33–8599 (Aug. 5, 2005) [70 FR 45446]
(Dec. 16, 2004) (included as Appendix D). Appendix C. (included as Appendix H).
11 Advisory Committee on Smaller Public 18 The Chicago recommendations were submitted 21 llllllll, SEC Release No. 33–ll
Companies, SEC Release No. 33–8514 (Dec. 21, to the Commission by letter dated August 18, 2005 (2006).
2004) [69 FR 76498] (included as Appendix B). to SEC Chairman Christopher Cox, who had 22 All of the written submissions made to the
12 SEC Chairman Donaldson Announces Members
succeeded Chairman Donaldson. The text of the Committee are available in the SEC’s Public
of Advisory Committee on Smaller Public letter is included as Appendix L. The letter Reference Room in File No. 265–23 and on the
Companies, SEC Press Release No. 2005–30 (Mar. included copies of documents entitled ‘‘Six Committee’s Web page at http://www.sec.gov/rules/
7, 2005) (included as Appendix E). This press Determinants of a Smaller Public Company’’ and other/265-23.shtml. To avoid duplicative material
release describes the diverse backgrounds of the ‘‘Definition of Smaller Public Company,’’ which in footnotes, citations to the written submissions
Committee members. had been made available to the Committee before made to the Committee in this Final Report do not
13 See Committee Charter (included as Appendix it adopted its definition of the term ‘‘smaller public reference the Public Reference Room or repeat the
B). company.’’ Public Reference Room file number.
scalability of regulations based on lowest 1% to 5% of total U.S. equity companies would be entitled to the
company size. The task force developed market capitalization, with the result regulatory scaling provided by SEC
internal working guidelines for the that all companies comprising the regulations for companies of that size
subcommittees to use for this purpose lowest 6% would be considered for after study of their characteristics and
and reported them to the full Committee scaled or proportional regulation.25 special needs.
at our August 10, 2005 meeting.23 We This new system would replace the
Under the system we are
voted to approve the guidelines, which SEC’s current scaling system for ‘‘small
recommending, microcap companies
are discussed in the next part of this business issuers’’ eligible to use
generally would be entitled to the
report. Regulation S–B 26 as well as the current
accommodations afforded to small
scaling system based on ‘‘non-
Part II. Scaling Securities Regulation accelerated filer’’ status,27 but would business issuers and non-accelerated
for Smaller Companies provide eligibility for scaled regulation filers under the SEC’s current rules.
We developed a number of for companies based on their size Smallcap companies would be entitled
recommendations concerning the relative to larger companies.28 to whatever accommodations the SEC
Commission’s overall policies relating Under our recommended system, decides to provide them in the future.
to the scaling of securities regulation for companies would be eligible for special As discussed below, we are
smaller public companies. As discussed scaled or proportional regulation if they recommending that the SEC provide
below, we believe that these fall into one of two categories of smaller certain relief under Sarbanes-Oxley Act
recommendations are fully consistent public companies based on size. We call Section 404 to certain smaller public
with the original intent and purpose of one category ‘‘microcap companies’’ and companies.31 We also are
our Nation’s securities laws.24 We the other ‘‘smallcap companies.’’ Both recommending that the SEC permit
believe that, over the years, some of the categories of companies would be smaller public companies to follow the
original principles underlying our included in the category of ‘‘smaller financial statement rules now followed
securities laws, including public companies’’ that qualify for the by small business issuers under Item
proportionality, have been new scaled regulatory system. 310 of Regulation S–B rather than the
underemphasized, and that the Companies whose common stock (or financial statement rules in Regulation
Commission should seek to restore equivalent) in the aggregate comprises S–X currently followed by all
balance in these areas where the lowest 1% of total U.S. equity companies that are not small business
appropriate. market capitalization (companies with issuers.32
Our primary recommendation equity capitalizations below Our primary reason for
concerning scaling, and one that approximately $128 million 29) would recommending special scaled regulation
underlies several other qualify as microcap companies. for companies falling in the aggregate in
recommendations that follow in this Companies whose common stock (or the lowest 6% of total U.S. equity
report, is as follows: equivalent) in the aggregate comprises market capitalization is that this cutoff
the next lowest 5% of total U.S. equity assures the full benefits and protection
Recommendation II.P.1 market capitalization (companies with of federal securities regulation for
Establish a new system of scaled or equity capitalizations between
companies and investors in 94% of the
proportional securities regulation for approximately $128 million and $787
total public U.S. equity capital
smaller public companies using the million) generally would qualify as
markets.33 This limits risk and exposure
following six determinants to define a smallcap companies.30 Smallcap
to investors and protects investors from
‘‘smaller public company’’: serious losses (e.g., 100 bankruptcies
The total market capitalization of the 25 Mr. Schacht abstained from voting on this
recommendation. All other members present voted companies with $10 million total
company;
in favor of this recommendation. market capitalization would be required
■ A measurement metric that 26 Regulation S–B can be found at 17 CFR 228.
to equal the potential loss of the
facilitates scaling of regulation; 27 ‘‘Non-accelerated filers’’ are public companies
■ A measurement metric that is self- bankruptcy of a company with $1
that do not qualify as ‘‘accelerated filers’’ under the
calibrating; SEC’s definition of the latter term in 17 CFR
billion of market capitalization). Our
■ A standardized measurement and 240.12b–2, generally because they have a public recommended standard acknowledges
methodology for computing market float of less than $75 million. Companies that do the relative risk to investors and the
not qualify as accelerated filers have more time to capital markets as it is currently used by
capitalization; file their annual and quarterly reports with the SEC
■ A date for determining total market and have not yet been required to comply with the professional investors.
capitalization; and internal control over financial reporting In addition, we considered the SEC’s
■ Clear and firm transition rules, i.e., requirements of Sarbanes-Oxley Act Section 404.
28 We believe our recommended system
recent adoption of rules reforming the
small to large and large to small. complements the SEC’s recently promulgated
Develop specific scaled or securities offering reforms, which are principally 31 See the discussion in Part III below.
proportional regulation for companies available to a category of public companies with 32 See the discussion in Part IV below.
under the system if they qualify as over $700 million in public float known as ‘‘well- 33 We recognize that, if the Commission
known seasoned issuers.’’ We recognize, however, determines to implement our recommendation, it
‘‘microcap companies’’ because their that the Commission will need to assure that our may want to examine the distinguishing
equity market capitalization places them recommendations, if adopted, are integrated well characteristics of the group of ‘‘smaller public
in the lowest 1% of total U.S. equity with the categories of companies established in the companies’’ to which it intends to provide specific
market capitalization or as ‘‘smallcap securities offering reform initiatives. regulatory relief. We have done this in developing
29 SEC Office of Economic Analysis, Background
companies’’ because their equity market our recommendations set out in ‘‘Part III. Internal
Statistics: Market Capitalization and Revenue of Control Over Financial Reporting.’’ A comment
capitalization places them in the next Public Companies (Aug. 2, 2005) (included as letter recently sent to the Commission also went
Appendix I). Data was derived from Center for through this exercise in making recommendations
23 See Record of Proceedings 62–103 (Aug. 10, Research in Security Prices (CRSP) for 9,428 New with respect to application of Section 404 of the
2005). York and American Stock Exchange companies as Sarbanes-Oxley Act to smaller public companies.
24 For background on the history of scaling federal of March 31, 2005 and from NASDAQ for NASDAQ See Letter from BDO Seidman, LLP, at 2–3 (Oct. 31,
securities regulation for smaller companies, see the Stock Market and OTC Bulletin Board firms as of 2005) (on file in SEC Public Reference Room File
discussion under the caption ‘‘—Commission Has a June 10, 2005. No. S7–06–03), available at http://www.sec.gov/
Long History of Scaling Regulation’’ below. 30 Id. rules/proposed/s70603/bdoseidman103105.pdf.
securities offering process.34 Reporting specify how companies would move deciding for legal purposes which
companies with a public float of $700 from one category to another in the holdings are public float and which are
million or more, called ‘‘well-known reverse order, from no scaling not.39 This can be a subjective
seasoned issuers,’’ generally will be entitlement to smallcap company determination; not all companies reach
permitted to benefit to the greatest treatment to microcap entitlement. The the same conclusions on this issue
degree from securities offering reform. SEC has experience and precedents to based on similar facts, which can lead
We are hopeful that the Commission follow in its transition rules governing to problems of comparability.
will see fit to adopt a disclosure system movement to and from Regulation S–B In formulating our scaling
applicable to ‘‘smaller public and Regulation S–K, non-accelerated recommendation, we considered a
companies’’ that integrates well with the filer status and accelerated filer status, number of alternatives to market
disclosure and other rules applicable to and well-known seasoned issuer capitalization as the primary metric for
‘‘well-known seasoned issuers.’’ We eligibility and non-eligibility. determining eligibility for scaling,
believe that companies that qualify as We believe that our plan for providing including revenues. Ultimately,
‘‘smaller public companies’’ on the basis scaled regulatory treatment for smaller however, we felt that any benefits to be
of equity market capitalization should public companies contains features that derived from adding additional metrics
not also qualify as ‘‘well-known recommend it over some other SEC to the primary formula were outweighed
seasoned issuers.’’ regulatory formats. For example, it by the additional complexity that
We recommend that the SEC provides for a flexible measurement that introduction of those additional size
implement this recommendation by can move up and down, depending on parameters would entail. We wish to
promulgating regulations under which stock price and other market levels. It make it clear, however, that we believe
all U.S. companies with equity avoids the problem of setting a dollar that additional determinants based on
securities registered under the Exchange amount standard that needs to be other metrics of size may be appropriate
Act would be ranked from largest to revisited and rewritten from time to in the context of individual securities
smallest equity market capitalization at time, and consequently provides a long- regulations. For example, our own
each recalculation date.35 The ranges of term solution to the problem of re- recommendations on internal control
market capitalizations entitling public scaling securities regulation for smaller over financial reporting contain metrics
companies to qualify as a ‘‘microcap public companies every few years. conditioning the availability of scaling
company’’ and ‘‘smallcap company’’ Finally, assuming the plan is treatment on company annual revenues.
would be published soon after the implemented as we intend, the system
Commission Has a Long History of
recalculation. These ranges would would provide full transparency and
Scaling Regulation
remain valid until the next recalculation allow each company and its investors to
determine the company’s status in Since federal securities regulation
date. Companies would be able to
advance or at any time based on began in the 1930’s, it has been
determine whether they qualify for
publicly available information. This recognized that some companies and
microcap and smallcap company
would allow companies to plan for transactions are of insufficient
treatment by comparing their market
transitions suitably in advance of magnitude to warrant full federal
capitalization on their determination
compliance with new regulations. regulation, or any federal regulation at
date, presumably the last day of their
We recommend that the SEC use all. Smaller public companies primarily
previous fiscal year, with the ranges
equity market capitalization, rather than have been subject to two securities
published by the SEC for the most
public float, to determine eligibility for statutes, the Securities Act and the
recent recalculation date.36 The Exchange Act. The Securities Act,
smaller public company treatment for
determination so would then be used to originally enacted to cover distributions
several reasons.37 We are aware that the
by companies to determine their status of securities, has from the beginning
SEC historically has used public float as
for the next fiscal year. This is what we contained a ‘‘small issue’’ exemption in
a measurement in analogous regulatory
mean when we say that the Section 3(b) 40 that gives the SEC
contexts.38 However, we recommend
measurement metric for determining rulemaking authority to exempt any
that the SEC use equity capitalization,
smaller public company status should securities issue up to a specified
rather than public float, to determine
be ‘‘self-calibrating.’’ maximum amount. This amount has
eligibility for smaller public companies
In promulgating these rules, the SEC grown in stages, from $100,000 in 1933
for several reasons. First, we believe that
will need to establish clear transition to $5 million since late 1980.41 The
equity market capitalization better
rules providing how companies would Exchange Act originally was enacted to
measures total risk to investors
graduate from the microcap category to regulate post-distribution trading in
(including affiliates, some of whom may
the smallcap category to the realm securities. It did so by requiring
not have adequate access to
where they would not be entitled to registration by companies of classes of
information) and the U.S. capital
smaller public company scaling. The
markets than public float, and
transition rules would also need to
consequently that it is the most relevant 39 Because public float by definition excludes
measure in determining which shares held by affiliates, calculation of public float

34 See Securities Offering Reform, SEC Release relies upon an accurate assessment of affiliate status
No. 33–8591 (July 19, 2005) [70 FR 44722]. companies initially should qualify for of officers, directors and shareholders. As the
35 We leave to the Commission’s discretion the scaled securities regulatory treatment Commission acknowledged in the Rule 144 context,
frequency with which this recalculation should based on size. We also believe that using this requires a subjective, facts and circumstances
occur, but note that frequent recalculation, even on market capitalization has the additional determination that entails a great deal of
an annual basis, could introduce an undesirable uncertainty. See Revision of Rule 144, Rule 145 and
level of uncertainty into the process for companies
advantage of simplicity, as it avoids Form 144, SEC Release No. 33–7391 (Feb. 20, 1997)
trying to determine where they fall within the three what can be the difficult problem of [62 FR 9246].
categories. 40 15 U.S.C. 77c(b).

36 In formulating this recommendation, we looked 37 The Commission would, of course, need to 41 Louis Loss & Joel Seligman, Fundamentals of
for guidance at the method used to calculate the prescribe a standardized methodology for Securities Regulation 387 (2004). The Commission
Russell U.S. Equity Indexes. For more information computing market capitalization. has adopted a number of exemptive measures for
on Russell’s method, see Russell U.S. Equity 38 For example, a public float test is used to small issuers pursuant to its authority under
Indexes, Construction and Methodology (July determine a company’s eligibility to use Forms SB– Section 3(b), including Rules 504 and 505,
2005)), available at www.russell.com. 2, F–3 and S–3 and non-accelerated filer status. Regulation A and the original version of Rule 701.
their securities. At first, the Exchange and ‘‘non-accelerated filers,’’ and in • The lack of sufficient resources and
Act required companies to register only 2005 added a third category of ‘‘large competencies in an area in which
if their securities were traded on a accelerated filers,’’ providing scaled companies and auditors have previously
national securities exchange. This securities regulation for these three tiers placed less emphasis.
assured that smaller companies of of reporting companies.49 Non- But because of their different
insufficient size to warrant exchange accelerated filers are fundamentally operating structures, smaller public
listing would not be subject to overly public companies with a public float companies have felt the effects of
burdensome federal securities below $75 million, and large accelerated Section 404 in a manner different from
regulation. filers are public companies with a their larger counterparts. With more
In 1964, Congress extended the reach public float of $700 million or more.50 limited resources, fewer internal
of most of the Exchange Act’s public Notwithstanding the benefits to which personnel and less revenue with which
company provisions to cover companies smaller business issuers and non- to offset both implementation costs and
whose securities trade over-the- accelerated filers are entitled under the the disproportionate fixed costs of
counter.42 Since all securities other than Commission’s current rules, we believe Section 404 compliance, these
exchange-listed securities technically significant changes to the federal companies have been disproportionately
trade ‘‘over-the-counter,’’ this expansion securities regulatory system for smaller subject to the burdens associated with
required limiting the companies covered public companies, such as those Section 404 compliance. Moreover, the
to avoid creating a burden on issuers recommended in this report, are benefits of documenting,52 testing and
and the Commission that was required to assure that it is properly certifying the adequacy of internal
‘‘unwarranted by the number of scaled for smaller public companies. controls, while of obvious importance
investors protected, the size of Our experience with smaller public for large multinational corporations, are
companies affected, and other factors companies, as well as the testimony and of less certain value for smaller public
bearing on the public interest.’’ 43 written statements we received, support companies, who rely to a greater degree
Congress wanted to ensure that ‘‘the this view. We believe that the problem on ‘‘tone at the top’’ and high-level
flow of reports and proxy statements of improper scaling for smaller public monitoring controls, which may be
[would] be manageable from the companies has existed for many years, undocumented and untested, to
regulatory standpoint and not and that the additional regulations influence accurate financial reporting.
disproportionately burdensome on imposed by the Sarbanes-Oxley Act The result is a cost/benefit equation
issuers in relation to the national public only exacerbated the problem and that, many believe, diminishes
interest to be served.’’ 44 Accordingly, caused it to become more visible. shareholder value, makes smaller public
Congress chose to limit coverage to companies less attractive as investment
Part III. Internal Control Over
companies with a class of equity opportunities and impedes their ability
Financial Reporting
security held of record by at least 500 to compete.
persons and net assets above $1 Introduction This last factor is particularly
million.45 Over time, the standard set by From the earliest stages of its problematic in light of the crucial role
Congress at 500 equity holders of record implementation, Sarbanes-Oxley Act smaller public companies play in job
and $1 million in net assets required Section 404 has posed special creation and economic growth. In
adjustment to assure that the burdens challenges for smaller public addition, we are increasingly
placed on issuers and the Commission companies. To some extent, the participating in a global economy and
were justified by the number of problems smaller companies have in (1) the much higher costs for Sarbanes-
investors protected, the size of complying with Section 404 are the Oxley compliance in general, and
companies affected, and other factors problems of companies generally: Section 404 compliance in particular,
bearing on the public interest, as • Lack of clear guidance; (2) the loss of foreign issuers who are
originally intended by Congress. The • An unfamiliar regulatory either not listing in the U.S. or are
Commission has raised the minimum environment; departing from U.S. markets and (3)
net asset level several times; it now • An unfriendly legal and domestic issuers who are going dark or
stands at $10 million.46 enforcement atmosphere that private could pose significant
In 1992, the Commission adopted diminishes the use and acceptance of competitive risks to U.S. companies and
Regulation S–B,47 a major initiative that professional judgment because of fears markets.53
allows companies qualifying as ‘‘small of second-guessing by regulators and the
business issuers’’ (currently, companies plaintiff’s bar; 51 52 SEC rules require that a company maintain
with revenues and a public float of less • A focus on detailed control evidential matter, including documentation, to
than $25 million 48) to use a set of provide reasonable support for management’s
activities by auditors; and assessment of the effectiveness of the company’s
abbreviated disclosure rules scaled for internal control over financial reporting. See
smaller companies. In 2002, the 49 See Acceleration of Periodic Report Filing
Section II.B. of Management’s Reports on Internal
Commission divided public companies Dates and Disclosure Concerning Web site Access Control Over Financial Reporting and Certification
into two categories, ‘‘accelerated filers’’ to Report, SEC Release No. 33–8128 (Sept. 16, 2002) of Disclosure in Exchange Act Periodic Reports,
[67 FR 58480]. SEC Release No. 33–8238 (June 5, 2003) [68 FR
50 17 CFR 240.12b–2. Both accelerated filers and 36636]. See note 58 infra.
42 Securities Acts Amendments of 1964, Pub. L.
large accelerated filers must also have been 53 See William J. Carney, The Costs of Being
No. 88–467, 78 Stat. 565 (adding Section 12(g), reporting for at least 12 months, have filed at least Public After Sarbanes-Oxley: The Irony of ‘Going
among other provisions, to the Exchange Act). one annual report and not be eligible to use Forms
43 S. Rep. No. 88–379, at 19 (1963).
Private,’ Emory Law and Economics Research Paper
10–KSB and 10–QSB. No. 05–4 at 1 (Feb. 2005), available at SSRN:
44 Id.
51 See Conference Panelists Discuss Earnings http://ssrn.com/abstract=672761 (‘‘In an
45 15 U.S.C. 78l(g).
Guidance and Accounting Issues, SEC Today (Feb. economically rational world we don’t want to
46 17 CFR 240.12g5–1.
14, 2006), at 2 (quoting Teresa Iannaconi as stating prevent all fraud, because that would be too
47 17 CFR 228.10 et seq. that while she believes the PCAOB is sincere in its expensive. Instead, the goal should be to keep on
48 17 CFR 228.10(a)(1). ‘‘Small business issuers’’ attempt to bring greater efficiency to the audit spending on fraud prevention until the returns on
must also be U.S. or Canadian companies, not process, accounting firms are not ready to step back, a dollar invested in prevention are no more than a
investment companies and not majority owned because they have all received deficiency letters, dollar. There is an ‘Optimal Amount of Fraud.’ ’’);
subsidiaries of companies that are not small none of which say that the auditors should be doing Roberta Romano, The Sarbanes-Oxley Act and the
business issuers. less rather than more). Continued
We acknowledge that in the course of Because an appreciation of the the U.S. and the framework used by
our deliberations we heard certain existing Section 404 problem requires virtually all U.S. companies.58
respected persons question whether the an understanding of the problem’s As noted above, during the early
Section 404 problem for smaller public origin, we have included below a brief stages of implementation of Section 404,
companies is, in fact, overstated.54 In background section, followed by an it became clear that smaller public
the view of some, the benefits of Section overview of our recommendations and companies, due to their size and
404 for small companies outweigh the the recommendations themselves. structure, were experiencing significant
costs, authoritative guidance for smaller challenges, both in implementing that
public companies will provide issuers Background of Section 404 provision’s requirements and in
with sufficient guidance in areas where applying the SEC and PCAOB-endorsed
Sarbanes-Oxley Act Section 404 COSO Framework. Many expressed
clarity is currently lacking, and at any
directed the SEC to adopt rules serious concerns about the ability to
rate Section 404 expenditures will
requiring all reporting companies, other apply Section 404 to smaller public
decrease substantially as issuers and
their auditors become more familiar than registered investment companies, companies in a cost-effective manner,
with the law’s requirements. However, to include in their annual reports a and also about the need for additional
the experience of most of our members, statement of management’s guidance for smaller businesses in
and the outpouring of testimony, responsibility for establishing and applying the COSO Framework. Against
comment letters and input we received, maintaining adequate internal control this backdrop, and at the encouragement
suggests otherwise. over financial reporting, together with of the SEC staff, COSO in October 2005
After thorough consideration of the an assessment of the effectiveness of issued for public comment an exposure
evidence presented, we believe that those internal controls. Section 404 draft entitled ‘‘Guidance for Smaller
Section 404 represents a clear problem further required that the company’s Public Companies Reporting on Internal
for smaller public companies and their independent auditors attest to, and Control over Financial Reporting.’’ 59
investors, one for which relief is report on, this management assessment. While intended to provide much needed
urgently needed. Our recommendations clarity, the guidance has to date
In accordance with Congress’
as to how to improve the existing received mixed reviews, with many
directive, on June 5, 2003 the
structure, consistent with investor questioning whether it will significantly
Commission adopted the basic rules
protections, are discussed below. change the disproportionate cost and
implementing Section 404 with regard
Although these recommendations are other burdens or the cost/benefit
to management’s obligations to report equation associated with Section 404
based upon 13 months of intensive on internal control over financial
study and debate, they essentially compliance for smaller public
reporting.55 In addition, on June 17, companies.60
derive from a few fundamental ideas: 2004 the Commission issued an order
the primary objective of internal control approving PCAOB Auditing Standard 58 COSO is a voluntary private sector organization
over financial reporting requirements No. 2, entitled An Audit of Internal sponsored by the American Institute of Certified
should be the prevention of materially Control over Financial Reporting Public Accountants (AICPA), the American
inaccurate financial statements; Performed in Conjunction with an Audit Accounting Association, Financial Executives
companies operate differently, International, the Institute of Internal Auditors, and
of the Financial Statements (AS2), the Institute of Management Accountants. COSO
depending on size, and internal control which established the requirements that published the COSO Framework, formally titled
rules should reflect this fact; and the ‘‘Internal Control—Integrated Framework, in 1992.
apply to an independent auditor when
benefits of any regulatory burden— The COSO Framework is available at http://
performing an audit of a company’s www.coso.org/publications/
Section 404-related or otherwise—
internal control over financial executive_summary_integrated_framework.htm.
should outweigh the costs.
reporting.56 The rules adopted by the The COSO Framework presents a common
Commission and the PCAOB definition of internal control and provides a
Making of Quack Corporate Governance, 114 Yale framework against which internal controls within a
L. J. 1521, 1587–91 (2005); Joseph A. Grundfest, implementing Section 404 require company can be assessed and improved. Under the
Fixing 404 (2005) (unpublished manuscript, on file management to base its evaluation of COSO Framework, internal control over financial
in SEC Public Reference Room File No. 265–23) internal control over financial reporting reporting is defined as a process, effected by an
(‘‘While there is substantial debate over the costs entity’s board of directors, management and other
on a suitable, recognized control personnel, designed to provide reasonable
and benefits of Section 404 as implemented by
PCAOB Statement No. 2, there is far greater framework that is established by a body assurance regarding the achievement of objectives
consensus that these rules are not cost effective. Put or group that has followed due-process in the reliability of financial reporting. Internal
another way, regardless of whether Section 404’s procedures, including the broad control over financial reporting includes five
social benefits exceed its social costs, a very large interrelated components: Control environment, risk
portion of Section 404’s benefits can be generated
distribution of the framework for public assessment, control activities, information and
while imposing substantially lower costs on the comment.57 Commission rules communication, and monitoring. The COSO
economy. Consistent with this view, the current implementing both Section 404 and AS2 Framework recognizes that formal documentation is
head of the PCAOB states ‘It is * * * clear to us not always necessary, and that informal and
specifically identify the internal control undocumented controls, even when communicated
that the first sound of internal control audits cost
too much.’ ’’) Moreover, Congress, in the form of framework published by the Committee orally, can be highly effective. See COSO
Securities Act Section 2(b), has mandated that of Sponsoring Organizations of the Framework at 30, 73.
whenever the SEC engages in rulemaking it is Treadway Commission (COSO) (the 59 Available at http://www.ic.coso.org.
required to consider in addition to the protection COSO Framework) as suitable for such 60 Several comment letters submitted to COSO in
of investors, whether the action will promote respect of the guidance are illustrative, including
efficiency, competition and capital formation. See purposes, and indeed, the COSO the following: Letter from PCAOB to COSO (Jan. 18,
Peter J. Wallison, Buried Treasure: A Court Framework has emerged as the only 2006) (‘‘[S]ome of the approaches and examples in
Rediscovers A Congressional Mandate the SEC Has internal control framework available in the draft may be inappropriate or impractical for the
Ignored, AEI Online (Oct. 2005) available at http:// smallest public companies. We recommend that
www.aei.org/publications/pubID.23310/ COSO reconsider whether there is additional, more

55 SEC Release No. 33–8238 (June 5, 2003) [68 FR
pub_detail.asp. See also infra notes 87 through 90 practical advice that COSO could give to such
and accompanying text. 36636]. companies.’’); Letter from Institute of Management
54 See, e.g., Record of Proceedings 64 (Sept. 19, 56 SEC Release No. 34–49884 (June 17, 2004) [69
Accountants to COSO (Oct. 24, 2005) (‘‘The IMA is
2005) (testimony of Lynn E. Turner), available at FR 35083]. unclear as to how this guidance, built on the
http://www.sec.gov/info/smallbus/acspc/ 57 See Exchange Act Rules 13a–15(c) and 15d– existing COSO Framework, tangibly reduces SOX
acspctranscript091905.pdf. 15(c), 17 CFR 240.13a–15(c) & 240.15d–15(c). compliance costs for small businesses or businesses
Reporting companies initially were to engagement.’’ 65 Moreover, the Senate intent. In both instances, what began
be required to comply with the internal Committee Report that accompanied with an idea with which few would
control reporting provisions for the first Section 404 to the Senate floor included disagree—that companies should have
time in connection with their fiscal the following language: in place effective controls over their
years ending on or after June 15, 2004 In requiring the registered public transactions and dispositions of assets—
(accelerated filers) 61 or April 15, 2005 accounting firm preparing the audit report to unexpectedly became a source of
(non-accelerated filers and foreign attest to and report on management’s significant anxiety, activity and
private issuers). Recognizing the assessment of internal controls, the expense.
importance of these provisions and the Committee does not intend that the auditor’s With respect to the FCPA, the fears of
time necessary to implement them evaluation be the subject of a separate public companies and their advisors
properly, on February 24, 2004 the engagement or the basis for increased charges were put to rest by a speech that then
or fees. High quality audits typically
Commission extended these compliance SEC Chairman Harold Williams gave in
incorporate extensive internal control testing.
dates to fiscal years ending after The Committee intends that the auditor’s 1981, in which he outlined a
November 15, 2004 for accelerated filers assessment of the issuer’s system of internal Commission approach to FCPA
and July 15, 2005 for non-accelerated controls should be considered to be a core compliance based upon reasonableness
filers and foreign private issuers.62 responsibility of the auditor and an integral and minimal intrusion in internal
On March 2, 2005, the Commission part of the audit report.66 corporate decision making.70 The
further extended the compliance dates Additionally, the Commission’s June speech was adopted by the Commission
for non-accelerated filers and foreign 2003 release adopting internal control as an official agency interpretation and
private issuers to fiscal years ending rules, which predated adoption and policy statement, and retains that status
after July 15, 2006.63 Additionally, due approval of AS2, estimated that the to this day.71 Chairman Williams’
to the continuing evaluation of the average annual internal cost of approach served to calm much of the
impact of the Section 404 requirements compliance with Section 404 over the anxiety that had arisen, and his address
on smaller public companies by this first three years would be $91,000, and and the Commission’s adoption of it as
Committee, on September 21, 2005, the that cost would be proportional relative official agency policy are not only
Commission provided an additional to the size of the company.67 The reality instructive, but also are relevant to
one-year extension of the compliance has, of course, been much different. today’s Section 404 environment. We
deadline for non-accelerated (but not The anxieties that Section 404 has urge the Commission to republish and
larger foreign) filers to fiscal years produced, and the heavy expenses that re-emphasize the Williams statement
ending after July 15, 2007.64 have been incurred in an attempt to and make it the framework for
comply with its requirements, parallel management’s establishment of internal
Unintended Consequences of Attempts
those experienced as a result of controls.
To Address Internal Controls
Congress’ last major initiative to address Origin of the Current Problem
The legislative history of Section 404 internal accounting controls, the
makes clear that regulators and Foreign Corrupt Practices Act of 1977, The expectation on the part of
members of Congress never anticipated or FCPA.68 That statute added two lawmakers and regulators in enacting
many of the challenges that Section 404 accounting requirements applicable to and implementing Section 404 was that
compliance has presented. Section 404 public companies under the Exchange if internal controls over financial
itself states that the auditor’s attestation Act, including Section 13(b)(2)(B), the reporting are operating effectively, then
‘‘shall not be the subject of a separate provision that requires public confidence in the financial statements
companies to devise and maintain a ipso facto will be higher. In theory, this
of any size.’’); Letter from Deloitte & Touche LLP
system of internal accounting controls idea appears sound, particularly for
to COSO (Dec. 30, 2005 (‘‘We believe that many of larger companies, where financial
the examples in the exposure draft are too high- sufficient to provide reasonable
level and generic and do not address the issues assurance that specified objectives are statement preparation relies heavily on
faced by smaller public companies.’’); Letter from attained.69 Then, as now, Congress acted the effective operation of business
Crowe Chizek and Company LLC to COSO (Dec. 29,
to address public concerns following process controls. The requirements that
2005) (‘‘While the document will help smaller management assess, and that the
companies, we do not believe that it will result in several high profile cases of corporate
substantial reduction in the cost of evaluating and malfeasance. And then, as now, external auditor attest to the adequacy
documenting the internal control process by arguably uncertain standards of of, internal controls likewise appear to
management, and on the cost to audit internal
compliance, combined with the threat of be sensible objectives.
controls by companies’ auditing firms.’’); Letter In practice, however, several factors
from Ernst & Young LLP to COSO (Jan. 15, 2006) significant liability for non-compliance,
have led to an unexpected explosion of
(‘‘[A]lthough we believe the Guidance will be an worked to create an atmosphere in
excellent implementation aid, we are less activity in connection with
which companies and their advisors
convinced that it will significantly reduce the cost implementing Section 404. First,
of 404 implementation for smaller companies, at strayed far from the statute’s original
although AS2 was developed as a guide
least to the degree expected by some.’’). All such
comment letters are available at http:// 65 15 U.S.C. 7262.
for external auditors in determining
www.ic.coso.org/coso/cosospc.nsf/ 66 S. Rep. No. 107–205, at 31 (2002). whether internal control over financial
COSO%20Public%20Comments%20Document.pdf. 67 See Sections IV and V of Management’s Reports reporting is effective, no similar guide
The Chairman of COSO made a presentation at our on Internal Control Over Financial Reporting and has been developed for management.
San Francisco meeting and met informally with Certification of Disclosure in Exchange Act Periodic
members of our Internal Control Over Financial
SEC rules require management to base
Reports, SEC Release No. 33–8238 (June 5, 2003)
Reporting Subcommittee. [68 FR 36636] (‘‘[W]e assumed that there is a direct
its assessment of internal control over
61 The term ‘‘accelerated filer’’ is defined in Rule
correlation between the extent of the burden and financial reporting on a suitable,
12b–2, 17 CFR 240.12b–2, under the Exchange Act, the size of the reporting company, with the burden
15 U.S.C. 78a et seq.
increasing commensurate with the size of the 70 See Foreign Corrupt Practices Act of 1977:
62 SEC Release No. 33–8392 (Feb. 24, 2004) [69 FR company.’’). The Commission did, however, Statement of Policy, SEC Release No. 34–17500
9722]. anticipate that for many companies the first-year (Jan. 29, 1981) [46 FR 11544] (presenting address by
63 SEC Release No. 33–8545 (Mar. 2, 2005) [70 FR internal cost of compliance would be well in excess SEC Chairman Harold Williams to AICPA Annual
11528]. of the average. Conference as Commission statement of policy)
64 SEC Release No. 33–8545 (Sept. 22, 2005) [70 68 Pub. L. No. 95–213, tit. I (1977). (included as Appendix M).
FR 11528]. 69 15 U.S.C. 78m(b)(2)(B). 71 17 CFR 241 (citing id.).
recognized control framework. Although scaled accordingly, neither AS2 nor any inspectors and the subsequent issuance
the COSO Framework provides criteria other source provides a clear definition of AS2 have altered auditor behavior
against which to assess internal control, or guide for management as to what and, we believe, has diminished the
it does not provide management with constitutes adequate internal controls exercise of professional judgment.75
guidance on how to document and test for smaller companies.73 As noted
internal control or how to evaluate above, COSO is developing guidance Disproportionate Impact: The Smaller
deficiencies identified. Consequently intended to facilitate the application of You Are, the Larger the Hit
AS2 has become the de facto guide for the COSO Framework in the small Studies into the consequences of
management, even though it was only business environment; however, the Section 404 indicate that actual average
intended to be used as an auditing draft guidance recently exposed for costs of Section 404 compliance have in
standard; management has tried to meet public comment by COSO does not fully fact been far in excess of what was
the same requirements as auditors in offer a solution for small businesses and originally anticipated. In addition,
performing their assessments, when in may not reduce costs of implementing although costs generally decline
fact management and auditors likely Section 404 in a small business following the first year of
perform their assessments of internal environment. implementation, a recent study
controls differently. Adding to the Moreover, even though auditors
commissioned by the Big Four
problem has been the absence of any maintain that they are already taking a
accounting firms acknowledges that
clear definition or guide as to what risk-based approach to the AS2 audit,
we heard significant testimony from second year total costs for public
constitutes adequate internal controls companies with a market capitalization
for smaller companies. This problem companies suggesting that
implementation of AS2 has resulted in between $75 million and $700 million
has been compounded by the different will still equal, on average,
requirements in Section 404 for very rigid, prescriptive audits as a result
of onerous AS2 requirements. Most approximately $900,000.76
management and for their external
auditors.72 Management must assess the issuer comments we received indicated But beyond the aggregate costs
effectiveness of the internal controls that auditors applied a one-size-fits-all involved with Section 404 compliance,
over financial reporting, while the standard, even as auditors maintained costs have been disproportionately
external auditor must report on whether that each audit stands on its own; as the borne by smaller public companies. The
management’s assessment of the Commission’s May 2005 guidance lack of proportionality of the cost and
effectiveness of internal control is fairly suggests, and the input we received amount of resources devoted to Section
stated and provide (attest to) a separate confirms, auditors in many instances 404 compliance for smaller public
opinion on whether the company’s utilize an approach that is ‘‘bottom-up’’ companies is evidenced by data which
internal control is effective. rather than ‘‘top-down.’’ 74 This results shows that the expected cost of Section
Second, as both accelerated filers and in audits that are not risk-based and, in 404 implementation, as a percentage of
non-accelerated filers busily prepared particular, involve extensive testing of revenue, is dramatically higher for
for the first audit of internal control and information technology (IT) controls. smaller public companies than it is for
as Section 404 implementation efforts The result is extensive focus by auditors larger public companies. The following
were taking place, there had been little on detailed processes, a number of chart illustrates this disparity: 77
attempt to tailor, or ‘‘scale’’ regulation to which create little or no risk to the
address the specific manner in which integrity of the financial statements. 75 See After Sarbanes-Oxley, National Law
smaller companies operate. Although Finally, the Sarbanes-Oxley Act Journal Online (Dec. 12, 2005) (remarks of former
created the PCAOB to monitor the SEC Commissioner Joseph Grundfest).
many feel that smaller companies are 76 See CRA International Sarbanes-Oxley Section
operationally different from larger performance of the external auditors. 404 Costs and Implementation Issues: Survey
companies in ways relevant to internal The creation of this regulatory Update, at 1. For further information concerning the
controls, and hence that small watchdog, the introduction of PCAOB impact of Section 404, see American Electronics
Association, Sarbanes-Oxley Section 404: The
companies’ internal controls and 73 Many believe that AS2, in practice, has proven ‘‘Section’’ of Unintended Consequences and Its
methods of evaluating them should be not to be scalable in a manner that would make it Impact on Small Business (Feb. 2005) and Financial
applicable in a cost-effective way to smaller Executives International, FEI Special Survey on
72 The distinction between the Section 404 companies. Although the PCAOB proposed for Sarbanes-Oxley Section 404 Implementation (Mar.
requirements for management versus those for the comment a draft AS2 that included an appendix for 2005). Although these studies are subject to further
external auditors is misunderstood, and often smaller companies, the appendix was not included critical analysis, they indicate considerably higher
overlooked. This distinction is important because in the version of AS2 that the PCAOB and, later, Section 404 compliance costs than the Senate, the
our recommendation is that as companies grow in the Commission approved. Additionally, the COSO SEC and others estimated.
size and complexity, they should take on more Framework includes some guidance regarding 77 This table is based on data from the Financial
expansive Section 404 requirements. For smaller smaller companies but it is minimal. Many Executives’ International study and estimates of the
companies, we think there should be a management observers acknowledge the need to scale for smaller Section 404 working group of the American
assertion as to the adequacy of the internal control public companies, but because of the challenges Electronics Association. We note that companies
over financial reporting, but that the need for the involved, have avoided attempting to scale despite with a market capitalization of less than $75 million
external auditor involvement does not arise until a such need. generally did not have to comply with Section 404
company reaches a certain size and complexity. 74 Despite the May 2005 guidance’s call for a more in 2004. Many expect that compliance costs for the
Therefore, there is a need for a definition and guide top-down, risk-based approach, testimony we heard smallest companies in the chart will consequently
for management on what are adequate internal indicated that such guidance has not substantially be much higher when such companies are required
controls for smaller companies. altered the approach of auditors. to comply.
We also note that external auditor fees percentage of revenue that has occurred between 2000 and 2004, and that the
have overall been increasing, both for companies of varying market fees for these smaller public companies
before and after implementation of the capitalizations, between 2000 and as a percentage of revenue have
Sarbanes-Oxley Act. The graph below 2004.78 This shows that external fees for remained many times higher than for
illustrates the change in external audit smaller public companies have roughly larger public companies over this
fees and audit related fees as a tripled as a percentage of revenue period.79
Many commentators, including the fees) on the cost borne by smaller public a key risk, and effective internal
Commission, the Big Four audit firms, companies, it is clear that this results in controls, particularly at the entity level,
NASDAQ and the American Electronics a significant disproportionate cost for need to be in place to prevent such
Association, have estimated that the their shareholders. overrides from occurring.80 In a smaller
external audit fees represent between public company, this risk is increased
Management Override and the Resulting
one quarter and one third of the total due to top management’s wider span of
Increase in Cost Structure for Smaller
cost of implementing Section 404. When control and more direct channels of
Public Companies
one factors in this multiplier (i.e., that communication. The concentration of
total Section 404 implementation costs We believe that the risk of decision-making authority at the top of
are three to four times external audit management override in any company is a typical smaller company results in
EN03MR06.001</GPH>
78 Source: SEC Office of Economic Analysis, been required to comply with that provision’s 80 See American Institute of Certified Public
Background Statistics: Market Capitalization and requirements. Accountants, Management Override of Internal
Revenue of Public Companies (Aug. 2, 2005) 79 Percentage growth varies depending on the size Controls: The Achilles’ Heel of Fraud Prevention
(included as Appendix I). We note that this graph (2005), available at ttp://www.aicpa.org/
of the company and measurement method. See
shows changes in fees for companies affected by
Tables 8, 10 & 23 in Appendix I. audcommctr/download/achilles_heel.pdf.
EN03MR06.000</GPH>
Section 404 and non-accelerated filers that have not
both an increased chance of fraud due quickly that is their single most effective effective at controlling this risk; we
to management override, and also, competitive strength. By their nature, believe there are more effective controls
conversely and more importantly, a smaller companies are more dynamic that can be put in place to reduce the
significant increase in the probability and are constantly evolving, changing risk of management override, especially
that errors or fraud in financial and growing more rapidly than larger at smaller companies. These include an
reporting will be discovered through an companies. This dynamic nature increased oversight role for the board
honest senior management process that requires frequent changes in process and audit committee, a more robust
directly oversees financial reporting.81 and more frequent job changes inside communication system between the
This dichotomy creates much of the the company, which limits their ability board and the executive levels of the
tension in the debate over Section 404. to have static processes that are well company, and increased scrutiny from
Some members of this Committee documented. It also creates the need for external auditors in key areas where
believe that this fundamental difference top management involvement and override can occur.85
in how large and small companies are review over financial reporting. Larger Third, the requirements of AS2 and
managed deserves more focus and, as a companies have more rigidly defined the requirements of auditors to
result, are of the view that strengthening roles and processes that enable them to document controls and the redundancy
internal controls over top management segregate duties to the extent that the of control testing creates an
in the smaller company will reduce the internal control environment can be environment in smaller companies that
risk of management override and will relied on for financial reporting. In fact, limit their ability to be flexible, and
provide investors better protection from it is essential that larger companies have thereby hinders their competitiveness.
a material fraud. Some also believe that, well-defined processes that enable them We believe strongly that the formation
in a smaller company, it is difficult if to create ‘‘boundaries’’ in order to be of new companies and their ability to
not impossible for a widespread fraud to efficient and effective in competing with access the U.S. capital markets in a
occur that does not involve senior other companies, both large and small. responsible manner should be
management. This is the basic difference between encouraged by all market participants.
In smaller companies, people wear large and small companies and is at the Therefore we believe investor risk
multiple hats. It simply is not feasible heart of the Committee’s protection should be encouraged. We
to have a person who focuses on a single recommendations. Simply put, well also strongly believe that a company
area. It also means that personnel need established boundaries and flexibility must focus on value creation for its
to be cross trained in multiple jobs in are incompatible and not totally investors, and that our
order to fill in as needed or when possible in a smaller company. Section recommendations strike a more
someone is absent. The result is that 404 and AS2 can be effective in larger appropriate balance between the costs
segregation of duties, a key element of companies because of the boundaries and benefits of Section 404.
effective internal control, may not be inherent in those companies. Many We also note that the AICPA’s
achievable to the extent desired. This believe that in a smaller company these Proposed Statement on Auditing
lack of segregation of duties requires requirements cause the company to lose Standards, Communication of Internal
senior management to be involved in all its flexibility, and as a result put these Control Related Matters Noted in an
material transactions and directly companies at a competitive Audit, could be adopted by the PCAOB
involved in financial reporting.82 disadvantage without significantly to improve communication on internal
Smaller companies, by their nature, improving investor protection. control matters between the auditor and
need to be flexible and the environment In our deliberations we focused on audit committee in the case of
they operate in requires them to make three financial reporting concerns as companies whose internal controls are
changes quickly in order to compete they relate to Section 404 applicability not audited pursuant to our
effectively with much larger and more to smaller public companies. First, the recommendation.
entrenched competitors. In fact, it is this lack of segregation of duties in these Moreover and very importantly, the
versatility and the ability to change companies creates an internal control application of not only Section 404 but
environment that is not primarily relied the other regulations adopted under
81 The COSO Framework described management
upon for financial reporting purposes by Sarbanes-Oxley have serious cost and
control activities for small and mid-size companies profitability ramifications for smaller
as follows: ‘‘Further, smaller entities may find that either management or auditors.83 It is
certain types of control activities are not always important to note that we believe these public companies in addition to the
relevant because of highly effective controls applied companies should be concerned with financial reporting and management
by management of the small or mid-size entity. For internal control, and we note that ample override aspects.
example, direct involvement by the CEO and other First, the flexibility and requirement
key managers in a new marketing plan, and law is on the books today that requires
retention of authority for credit sales, significant all public companies to have an to change quickly is imposed on the
purchases and draw downs on lines of credit, can effective internal control system in smaller company by the customer; i.e.,
provide strong control over those activities, place.84 The point is that in the smaller it is not management’s choice. It is what
lessening or obviating the need for more detailed the customer expects—indeed
control activities. Direct hands-on knowledge of public company, these controls are not
sales to key customers and careful review of key primarily relied upon for financial demands—for the smaller company’s
ratios and other performance indicators often can reporting and are at times ineffective at price, which often times is slightly
serve the purpose of lower level control activities preventing fraud at the executive level. higher than that charged by a larger
typically found in large companies.’’ COSO company. Flexibility and quick change
Framework at 56. Second, the significant risk of
82 The COSO Framework states: ‘‘An appropriate management override in all companies often means that processes and controls
segregation of duties often appears to present creates an increased need for entity change, and consequently that the
difficulties in smaller organizations, at least on the level controls and board oversight. At
surface. Even companies that have only a few 85 The COSO Framework states: ‘‘Because of the
employees, however, can usually parcel out their

the process level, controls are not critical importance of a board of directors or
responsibilities to achieve the necessary checks and comparable body, even small entities generally
83 Id.
balances. But if that is not possible—as may need the benefit of such a body for effective internal
occasionally be the case—direct oversight of the 84 See Exchange Act § 13(b)(2)(B), 15 U.S.C. controls.’’ p. 31. See also Exposure Draft of AICPA,
incompatible activities by the owner-manager can 78m(b)(2)(B) (codifying part of Foreign Corrupt Communication of Internal Control Related Matters
provide the necessary control.’’ Id. Practices Act of 1977, § 102, Pub. L. 95–213). Noted in an Audit (Sept. 1, 2005).
documentation of those controls change, Sarbanes-Oxley dramatically and direction. A number of data points lead
resulting in a cost of keeping adversely affect the cost structure of a us in this direction, but we recognize
documentation that remains more or small company. that the evidence has not been fully
less constant each year. Given this analyzed and it may be premature to
Overview of Recommendations
dynamic, for smaller companies the cost make any conclusions. Nevertheless, the
of documentation, preparation and As noted above, we believe that the following developments should be
testing under AS2 will not likely be crux of the existing problem, and the carefully monitored:
reduced as much as anticipated, and not cornerstone of our recommended • Some companies are either going
to the extent it will in larger companies solution, is that smaller and larger dark or going private or considering
with more stable, rigid processes. public companies operate in a very doing so; 87
Second, larger companies frequently different manner. As companies grow in • The London Exchange’s Alternative
have lower material costs and can size and complexity, they rely more on Investment Market (AIM) for smaller
leverage their buying power. It is not formal, prescriptive and transactional public companies is gaining
unusual to see a whole percentage point internal controls to maintain the momentum;88
difference in material costs between a operations of the company. This • Foreign new listings in the United
large company and a small company. sentiment was confirmed by the States during 2005 dropped
The small company must offset that significant input we received indicating considerably from the previous year; 89
large company advantage with their that small and typically less complex • Foreign issuers are departing from
package of value (service, superior companies are very different from larger the U.S. market (and their institutional
product, flexibility, adaptability). companies and therefore, the reforms investors are voting for their going
Because the price is often set by the made by the Commission and the stock offshore); and
customer, a smaller company must exchanges should be applied differently, • U.S. investors continue to invest in
squeeze profitability out of overhead. depending on the size of the company. foreign securities even though the
That aspect of the cost structure must be A number of witnesses challenged the
87 We received several answers to this effect in
smaller when compared to the large application of AS2 to smaller, less
response to Question 1 of Request for Public Input
company. It must both offset the higher complex businesses, regardless of by Advisory Committee on Smaller Public
material costs and also support structure, size or strategy. Faced with Companies, SEC Release No. 33–8599 (Aug. 5,
profitability, which is the ultimate this reality, and in order to properly 2005) available at http://www.sec.gov/rules/other/
determination of shareholder value. scale Section 404 treatment to ensure 265–23survey.shtml. See William J. Carney, The
Costs of Being Public After Sarbanes-Oxley: The
Increasing the burden for a small that the benefits of implementation Irony of ‘Going Private,’ Emory Law and Economics
company directly and quickly erodes outweigh burdens, we propose differing Research Paper No. 05–4 at 1 (February 2005)
shareholder value. Because the estimate 404 compliance requirements based available at SSRN: http://ssrn.com/
of the costs for Section 404 upon company size. By way of abstract=672761; Joseph N. DiStefano, Some Public
Firms See Benefit in Going Private, Phil. Inq., Jan.
implementation was underestimated so introduction to the recommendations 21, 2006 (reporting on a discussion at the 11th
dramatically (millions of dollars per below, we believe that two items bear Annual Wharton Private Equity Conference),
year, versus $91,000), the pain and loss mentioning at the outset: (1) The opt-in available at http://www.philly.com/mld/inquirer/
of value has been significantly greater approach of our recommendations and business/13676241.htm. The Ziegler Companies,
Inc. is an example of a public company that decided
for a small company. (2) the use of revenue filters as a means to delist from the American Stock Exchange and
Third, the Sarbanes-Oxley Act not of capturing company complexity and deregister under the Exchange Act. As reasons for
only added Section 404 costs and other consequently the cost-effectiveness of the delisting and deregistration, Ziegler said, among
burdens that fell disproportionately on other things: ‘‘the costs associated with being a
applying Section 404 requirements. reporting company under the ‘34 Act are significant
smaller companies, it introduced and are expected to continue to rise, thereby
burdens that, because of the nature of Opt-In Approach
diminishing the Company’s future profitability; the
smaller companies, will be ongoing An essential component of the benefits of remaining a listed company with
rather than one time. The incremental exemptive relief we are proposing for continued ’34 Act reporting obligations are not
sufficient to justify the current and expected future
cost of operating a board of directors, for smaller public companies is that an costs and no analysts cover the Company’s shares.’’
example, has increased because of issuer, through its board of directors, Ziegler’s shares are now traded in the Pink Sheets
higher director and officer insurance and in consultation with its audit and the company provides its shareholders with,
costs, the increased activity and committee and external auditor, could among other items, annual reports including
audited financial statements, news of important
oversight responsibilities of the very well decide not to take advantage events and a proxy statement. It also has a Web
compensation, audit and nominating of the exemptive relief available and page including financial and governance
committee, more costly legal and audit instead comply with the Section 404 information.
88 The AIM Market is actively and successfully
fees, and increased fees for independent rules applicable to larger public
prospecting for listing companies in the United
advisors to the committees, a new and companies.86 States. See G. Karmin and A. Luchetti, New York
sometimes uncontrollable expense. The Some argue that internal control over Loses Edge in Snagging Foreign Listings, Wall St. J.,
pass-through cost from the supply chain financial reporting should be beneficial Jan. 26, 2006, at C1, and Stephen Taub, VCs Look
(for Sarbanes-Oxley) is starting to find to smaller public companies because it For Payday in London, CFO.com, Feb. 3, 2006,
available at http://www.cfo.com/article.cfm/
its way into the overall cost structure. will make it easier for them to attract 5487545/c_5486496?f=TodayInFinance_Inside. See
These are compounding the increased capital. At this point in the also Letter from John P. O’Shea to Committee (June
burden cost and they are repetitive—not development of the internal control 16, 2005), available at http://www.sec.gov/rules/
one time—costs. requirements, we think the evidence is other/265–23/jposhea061605.pdf. See also Record
In summary, these characteristics, of Proceedings 189 (Aug. 9, 2005) (testimony of
quite mixed on this question and, if James P. Hickey, Principal, Co-Head of Technology
result in frequent documentation change anything, is tending in the opposite Group, William Blair & Co. indicating that strong
and sustained review and testing for
IPO candidate elected to go public on the AIM

certification under Section 404, the cost 86 For a discussion of the benefits of such an exchange expressly to avoid costs and burdens of
of which is more of a sustained annual optional approach, as well as the circumstances that Sarbanes-Oxley Act compliance).
led to the formation of our Committee, see Roberta 89 See Patrick Hosking, Cull of U.S. Investors Set
cost. This forced cost choice, combined Romano, The Sarbanes-Oxley Act and the Making a Worrying Precedent, Times Online, Feb. 2, 2006.
with increased board operation costs of Quack Corporate Governance, 114 Yale L.J. 1521, available at http://business.timesonline.co.uk/
and other costs incurred as a result of 1595–1597 (2005). article/0,,13129–2020817,00.html.
issuers are not subject to internal internal controls to conduct the financial reporting and their material
control requirements like those financial statement audit than they do consequences and apply CEO and CFO
promulgated under Section 404.90 for companies with less revenues. certifications to such disclosures.91
Without deciding whether Section Specifically, auditors of smaller Moreover, management should be
404 is beneficial for investors in smaller companies and internal financial teams required to report on any known
public companies, we believe that in of smaller companies confirm that the material weaknesses. In this regard, the
light of our reasons for recommending smaller the company, the less valuable Proposed Statement on Auditing
exemptive relief for these companies, the internal control audit is to the Standards of the AICPA,
permitting them to comply or take financial statement audit. For smaller ‘‘Communications of Internal Control
advantage of the relief is the appropriate companies, the financial audits tend to Related Matters Noted in an Audit,’’ if
course of action to recommend. become more substantive in nature, adopted by the AICPA and the PCAOB,
with particular attention on key, high would strengthen this disclosure
Use of Revenue Filters
risk areas (inventory, revenue requirement and provide some external
We would add a revenue filter or recognition, etc.). Indeed, financial auditor involvement in the internal
criterion as a condition to providing experts testified that the larger the control over financial reporting process.
Section 404 exemptive relief for smaller company the more the auditor relies on Our first recommendation primarily
public companies, because we think the operation of internal controls to concerns microcap companies, which
that when evaluating the costs and perform the financial statement audit. represent the lowest 1% of total U.S.
benefits of applying the Section 404 This is because, the larger the company, equity market capitalization.92 In our
requirements to smaller public the more far flung and complex the view, these companies should be
companies, revenues are a very operations become and the less practical entitled to full Section 404 exemptive
important factor. We believe that it is to test significant numbers of relief, preconditioned upon their
companies with revenues in excess of transactions. compliance with the enhanced
$250 million are generally complex, and corporate governance provisions
hence rely more on process controls to Internal Control Over Financial described above.93 The following
generate their financial statements. Reporting—Primary Recommendations federal securities law requirements
Because auditors of such companies, as We recommend that the Commission would remain applicable to all
part of the financial audit, are likely to and other bodies, as applicable, companies that would qualify for full
have relied on and thus tested these effectuate the following: Section 404 relief in accordance with
internal controls as part of the financial this recommendation:
audit in the past, it is likely to be Recommendation III.P.1 • Maintain a system of internal
relatively less expensive, when Unless and until a framework for controls that provides reasonable
compared to smaller, less complex assessing internal control over financial assurances as to accuracy, as required
companies with respect to which reporting for such companies is
controls weren’t previously tested for developed that recognizes their 91 Messrs. Jensen, Schacht and Veihmeyer
purposes of the financial audit, to characteristics and needs, provide dissented from the majority vote on this
recommendation. The reasons for their dissents are
comply with Section 404. Conversely, exemptive relief from Section 404 contained in Parts VII, VIII and IX of this report.
we believe that companies with large requirements to microcap companies All other members present voted in favor of this
market capitalizations and minimal with less than $125 million in annual recommendation.
revenues, such as development stage revenue and to smallcap companies 92 The statistics we were provided indicate that
companies that trade on very large 4,641, or 49%, of the 9,428 U.S. public companies
with less than $10 million in annual would be eligible for exemptive relief under this
multiples because of potential, are product revenue that have or expand recommendation. See SEC Office of Economic
generally simple in terms of operations their corporate governance controls that Analysis, Background Statistics: Market
and pose a lesser risk of material include: Capitalization and Revenue of Public Companies,
financial fraud. Therefore, our • Adherence to standards relating to Tables 2, 19 & 26 (Aug. 2, 2005) (included as
Appendix I).
recommendations provide that a audit committees in conformity with 93 The approach adopted by the Committee has
smallcap company whose annual Rule 10A–3 under the Exchange Act; been raised as a possibility by various parties. See,
product revenue in the last fiscal year • Adoption of a code of ethics within e.g., Letter from Ernst & Young LLP to SEC, at 16
did not exceed $10 million would, the meaning of Item 406 of Regulation (Apr. 4, 2005) (Ernst & Young said, with a number
solely for purposes of our Section 404 of reservations, including the lack of sufficient
S–K applicable to all directors, officers information and longer term experience with 404:
recommendations, be treated the same and employees and compliance with the ‘‘Should the level of costs necessary to do the job
as a microcap company. further obligations under Item 406(c) right be determined to be unacceptable in relation
We acknowledge that there exists no relating to the disclosure of the code of to the benefits provided to investors in smaller
clear, obvious line for distinguishing public companies, the SEC could then consider
ethics; and using its exemptive authority to provide
between companies based on revenues. • Design and maintain effective alternatives, including annual reporting by
Our collective experience indicates, internal controls over financial management on the issuer’s internal controls over
however, that companies with revenues reporting. financial reporting with no auditor attestations or
of $250 million or more a year are In addition, as part of this with less frequent auditor attestations (for example,
getting large enough and complex auditor attestations every other year) or even
recommendation, we recommend that complete elimination of annual reporting by
enough that auditors rely more on the the Commission confirm, and if management on the issuer’s internal controls over
necessary clarify, the application to all financial reporting.’’) (on file in SEC Public
90 Record of Proceedings 100 (Oct. 14, 2005)
microcap companies, and indeed to all Reference Room File No. 4–497), available at
(testimony of Gerald I. White). See also Rebecca http://www.sec.gov/news/press/4-497/
Buckman, Tougher Venture: IPO Obstacles Hinder
smallcap companies also, of the existing eyllp040405.pdf. We note that Mr. Veihmeyer, in
general legal requirements regarding
Start-ups, Wall St. J., Jan. 25, 2006, at C1 (stating his discussion of reasons for dissenting from this
that ‘‘[l]ast year, 41 start-ups backed by venture- internal controls, including the recommendation (included in Part IX of this report),
capital investors became publicly traded U.S. requirement that companies maintain a states that after further study and experience with
companies, down from 67 in 2004 and 250 in the Section 404 ‘‘it may become evident * * * that an
boom year of 1999’’ and that ‘‘[o]verall IPO’s of U.S.
system of effective internal control over audit of internal control over financial reporting
companies also declined last year, but not as financial reporting, disclose may not be justified for certain very small public
sharply, to 215, from 237 in 2004’’). modifications to internal control over companies that evidence certain characteristics.’’
by Exchange Act Section 13(b)(2)(B) submissions by employees; the of Section 404. A recent integrity survey
enacted under the FCPA; authority to engage advisors; and undertaken by KPMG Forensic noted
• Provide chief executive officer and funding. The New York and American that employees who work in companies
chief financial officer certifications Stock Exchanges and the NASDAQ with comprehensive ethics and
under Sarbanes-Oxley Act Section Stock Market have now incorporated the compliance programs reported fewer
302; 94 requirements of Rule 10A–3 into their observations of misconduct and higher
• Receive external financial audits; respective listing standards. The audit levels of confidence in management’s
• Comply with the requirements of committee standards mandated by Rule commitment to integrity.97
Item 9A of Form 10–K and Item 4 of Part 10A–3 currently do not apply to any With regard to the penultimate
I of Form 10–Q; and smaller public companies that are not paragraph of the recommendation
• Disclose, consistent with current subject to those listing standards. We above, we simply wish for the
Section 404 rules, all material believe that if Section 404 relief is Commission to make clear, to the extent
weaknesses known to management, granted to the microcap and smallcap clarity is lacking, that those smaller
including those uncovered by the companies that we recommend for public companies qualifying for
external auditor and reported to the relief, those companies should, as a exemptive relief will continue to be
audit committee.95 condition to such relief, be required to required to (1) maintain a system of
For microcap companies that comply adhere to the audit committee standards internal control sufficient to provide
with these requirements, we envision embodied in Rule 10A–3. reasonable assurance that, among other
that full Section 404 relief would be Item 406 of Regulation S–K requires a things, transactions are recorded as
effective immediately. reporting company to disclose whether
While we are convinced that the costs necessary to permit preparation of
it has adopted a code of ethics that financial statements in conformity with
associated with Section 404 compliance applies to its principal executive officer,
are disproportionate and unduly GAAP, (2) disclose any modifications to
chief financial officer and other internal control over financial reporting
burdensome to smaller public appropriate executives and, if it has not
companies, we are also mindful of the and (3) certify such disclosures.
adopted such a code, to state why it has
Commission’s investor protection not done so. Item 406 defines a code of Recommendation III.P.2
mandate. We believe that our ethics to be written standards that are
recommendation provides a more cost- Unless and until a framework for
reasonably designed to deter assessing internal control over financial
effective method of enhancing investor wrongdoing and to promote: Honest and
protection. We believe that enhanced reporting for such companies is
ethical conduct, including handling of developed that recognizes their
audit committee standards and practices conflicts of interest; full, fair, accurate,
and the adoption and enforcement of characteristics and needs, provide
timely and understandable disclosure in exemptive relief from external auditor
ethics and compliance programs are reports and documents filed with the
effective, as well as cost-effective, involvement in the Section 404 process
Commission and in other public to the following companies, subject to
means of maintaining investor communications; compliance with
protections. their compliance with the same
applicable governmental laws, rules and corporate governance standards as
Rule 10A–3 under the Exchange Act
regulations; prompt internal reporting of detailed in the recommendation
requires national securities exchanges
violations of the code; and above: 98
and associations to prohibit the initial
accountability for adherence to the • Smallcap companies with less than
or continued listing of a security of an
code. A reporting company is also $250 million in annual revenues but
issuer that is not in compliance with
required to file a copy of its code of greater than $10 million in annual
specified listing standards relating to
ethics with the Commission as an product revenue; and
audit committees. These standards
exhibit to its annual report, or to post • Microcap companies with between
relate to: Audit committee member
the text of the code on its Web site. Item $125 and $250 million in annual
independence; responsibility for the
406 mandates disclosure as to whether revenue.99
appointment, compensation, retention
a code of ethics exists, but does not Smallcap companies that qualify for
and oversight of an issuer’s registered
require the adoption of a code. The the Section 404 external audit of
public accounting firm; the
major exchanges, including the NYSE, internal control relief still would be
establishment of procedures for the
AMEX and the NASDAQ Stock Market, subject to the rest of Section 404’s
receipt of accounting-related
go further and require, as part of their requirements, all otherwise applicable
complaints, including anonymous
listing standards, the adoption of a code federal securities law requirements and,
94 We expect that the Section 302 certifications of
of ethics meeting the fundamental in addition, in the case of companies
companies receiving exemptive relief from Section requirements embodied in Item 406, and not listed on the NYSE, AMEX or
404 would still be required to include the extend the coverage to the directors and NASDAQ Stock Market, all of the
introductory language in paragraph 4 of that employees of listed companies.96 As is
provision (which refers to the certifying officers’
corporate governance standards
responsibility for establishing and maintaining
the case with the audit committee
internal control over financial reporting) and standards described above, issuers not 97 KPMG Forensic Integrity Survey 2005–2006.
paragraph 4(b) (which refers to the internal control subject to listing standards requiring the 98 Messrs. Jensen, Schacht and Veihmeyer
over financial reporting having been designed to adoption of a code of ethics are not dissented from the majority vote on this
provide reasonable assurance regarding the recommendation. The reasons for their dissents are
reliability of financial reporting and the preparation
obligated to do so under Commission contained in Parts VII, VIII and IX of this report.
of financial statements). rules. We believe that the adoption and All other members present voted in favor of this
95 We considered other possible corporate enforcement of a code of ethics is both recommendation.
governance and disclosure standards that might be cost effective and appropriate for 99 The statistics we were provided indicate that
imposed as a condition to any Section 404 relief for smaller public companies that receive 1,957, or 21%, of the 9,428 U.S. public companies
smaller public companies. In the final analysis, would be eligible for exemptive relief under this
however, we felt that imposing conditions beyond relief from the attestation requirements recommendation. See SEC Office of Economic
those described above could result in hardship for Analysis, Background Statistics: Market
smaller public companies that would not be 96 New York Stock Exchange Rule 303A.10; Capitalization and Revenue of Public Companies,
commensurate with the benefits received from an NASDAQ Stock Market Rule 4350(n); AMEX Tables 2, 19 & 26 (Aug. 2, 2005) (included as
investor protection standpoint. Company Guide Sec. 807. Appendix I).
specified above applicable to companies Recommendation III.P.3 The Commission should direct the
so listed. Among the federal securities While we believe that the costs of the PCAOB to take the following steps:
law requirements that would remain requirement for an external audit of the • Develop a new audit standard for
applicable to all smallcap companies effectiveness of internal control over smaller public companies (ASX) that
that qualify for the Section 404 external financial reporting are disproportionate provides guidance for the external audit
audit of internal control exemptive to the benefits, and have therefore of only the design and implementation
relief would be the requirements to: adopted the second Section 404 of internal controls to make the work
• Maintain a system of internal performed by auditors on internal
recommendation above, we also believe
controls that provides reasonable controls more efficient for these
that if the Commission reaches a public
assurances as to accuracy, as required companies;
policy conclusion that an audit
by Exchange Act Section 13(b)(2)(B)
requirement is required, we recommend • Have the standard specify a report
enacted under the FCPA; that would be similar in scope to the
• Complete and report on that changes be made to the
requirements for implementing Section report described in Section 501.71 of
management’s assessment of internal Standards for Attestation engagements
control under Section 404; 404’s external auditor requirement to a
cost-effective standard, which we call (plus walkthroughs) of the AICPA; and
• Provide chief executive officer and • Help to ensure that the standard
chief financial officer certifications ‘‘ASX,’’ providing for an external audit
of the design and implementation of would meet the cost-effectiveness
under Section 302; requirement of the alternative
• Receive external financial audits; internal controls.101
If the Commission decides to pursue recommendation, by performing a cost-
• Comply with the requirements of benefit analysis before the standard is
Item 9A of Form 10–K and Item 4 of Part this non-preferred alternative
recommendation, we recommend that it issued in proposed form and a follow-
I of Form 10–Q; and up analysis before the standard is
• Disclose, consistent with current direct the PCAOB to take certain steps,
and consider taking certain other steps, considered for adoption.
Section 404 rules, all material
in connection with developing the The Commission should direct the
weaknesses known to management,
necessary new Audit Standard No. X, or PCAOB to consider taking the following
including those uncovered by the
ASX, described below. If those steps steps in developing ASX:
external auditor and reported to the
audit committee. have been taken and considered, • Involve all stakeholders in audits of
For smallcap companies that comply respectively, and complementary internal control and include a field trial
with these requirements, we envision additional guidance is available that period to ensure that the approach is
that Section 404 external audit of enables management to assess internal practical and results in achievement of
internal control relief would be effective controls in a cost-effective manner,102 required objectives;
immediately.100 this alternative recommendation should • Take into account that a company
be made effective for fiscal years starting would more likely engage its auditors to
100 We are aware that questions have arisen one year after the PCAOB issues conduct an AS2 audit as the company
regarding the Commission’s authority to provide ASX.103 gets more complex and the auditor
exemptive relief from full compliance with the plans or needs to place a high degree of
requirements of Section 404 in accordance with this
recommendation and the recommendation above. http://www.sec.gov/rules/proposed/s70603/ reliance on internal controls to
As a committee, we are not authorized or capable aba112805.pdf. We also are aware that the significantly reduce substantive audit
of rendering legal opinions on this issue. We are Commission’s broad rulemaking authority under procedures (but an auditor still would
aware, however, that Section 3(a) of the Sarbanes- Section 36(a)(1) of the Exchange Act may be be permitted to place reliance on
Oxley Act, 15 U.S.C. 7202(a), provides the exercised to provide exemptive relief from the
Commission with broad authority to promulgate requirements of Section 13(b)(2)(B) of the Exchange controls to reduce substantive testing in
‘‘such rules and regulations as may be necessary or Act, the provision that requires public companies selected areas by testing specific
appropriate in the public interest or for the to devise and maintain the systems of internal controls without performing an AS2
protection of investors’’ in furtherance of Section accounting controls that are the subject of audit); and
404. We believe that the relief we propose satisfies management’s internal control report and the
this standard and that the reasoning we have auditor’s report required under Section 404. We • Require that:
provided for our recommendations demonstrates also are aware that the Commission itself already ■ The same auditor perform and
the reasonableness of this conclusion. Furthermore, has provided exemptive relief from Section 404 for integrate the ASX and financial
we are aware of the view expressed by the certain reporting entities, such as asset-backed statement audits;
Committee on Federal Regulation of Securities of issuers, indicating that the SEC believes it has
the American Bar Association’s Section of Business exemptive authority to provide relief from technical ■ The auditor evaluate control
Law that the Commission has authority to provide compliance with Section 404. We believe the deficiencies identified during the
exemptive relief for smaller public companies from Commission could cite these and other authorities financial statement audit to determine
strict adherence to technical requirements of to demonstrate its authority to provide exemptive
relief from the requirements of Section 404. In
their impact as to the ASX audit; and
Section 404, as follows:
‘‘We believe the Commission’s authority [to addition, the Commission could consider applying ■ An auditor who identifies material
provide relief from the auditor attestation the canon of construction known as ‘‘in pari weaknesses in either the design or
requirements in Section 404(b) for smaller public materia’’ to construe Section 404 as subject to the operation of controls, should disclose
companies] stems from both the [Exchange Act] and Commission’s broad exemptive authority in the
Exchange Act because the two statutes relate to the
the material weaknesses in its report
[the Sarbanes-Oxley Act] itself. Section 36(a)(1) of
the Exchange Act gives the Commission broad same subject matter and must be construed and state that internal controls are not
exemptive authority under the Exchange Act. harmoniously. effective.
101 Mr. Barry abstained from the vote on this
[Sarbanes-Oxley] section 3(b)(1) provides that a
violation of [the Act’s provisions] will be treated as recommendation. Messrs. Jensen, Schlein and Internal Control Over Financial
a violation of the Exchange Act. Therefore, under Veihmeyer dissented from the majority vote on this Reporting—Secondary
Exchange Act Section 36(a)(1), the Commission can recommendation. Mr. Jensen’s and Mr. Veihmeyer’s Recommendations
adopt rules exempting classes of persons (here, reasons for their dissents are set forth in separate
In addition to the foregoing primary
smaller public companies) from compliance with statements in Parts VII and IX, respectively, of this
[Sarbanes-Oxley] provisions, including * * * report. recommendations in the area of internal
Section 404(b).’’ 102 The recommendation immediately below
control over financial reporting, we also
Letter from Committee on Federal Regulation of provides details regarding the additional guidance.
Securities, American Bar Ass’n, to SEC, p.4 n.2 103 We expect that the alternative set forth below for the Commission’s
(Nov. 28, 2005) (on file in SEC Public Reference recommendation could be effective for fiscal years consideration the following secondary
Room File Nos. S7–40–02 & S7–06–03), available at beginning after December 31, 2007. recommendations:
Recommendation III.S.1 • Emphasize that ‘‘materiality’’ for • Note the ability to rely on
Provide, and request that COSO and the purposes of evaluating a ‘‘material compensating controls, especially for
the PCAOB provide, additional weakness’’ is to be determined on an smaller public companies; and
guidance to help facilitate the annual but not on a quarterly basis (we • Suggest methods to reduce
assessment and design of internal note that this might require compliance costs relating to information
controls and make processes related to amendments to AS2 and SEC rules). technology controls, a significant source
internal controls more cost-effective; The Commission should also ask the of internal control compliance costs,
also, assess if and when it would be PCAOB to: consistent with the underlying risks.
• Address the ability to rely on In order to develop resources to
advisable to reevaluate and consider
compensating controls (especially for enhance the availability of additional
amending AS2.
Clear guidance does not yet exist for smaller public companies); guidance, the Commission could, for
smaller public company managers on • Describe ways to reduce example, allocate resources to develop a
how to develop and support a proper compliance costs relating to information free Web site with a title such as
Section 404 assessment of the technology controls, a significant source ‘‘Center of Excellence for Reporting and
effectiveness of internal control. of internal control compliance costs, Corporate Governance for Smaller
Section 404 requires management to consistent with the underlying risks; Public Companies.’’ The Web site could
report on its assessment of the and contain, for example, best practices,
effectiveness of the company’s internal • Provide for smaller public frequently asked questions and complex
controls and requires an external companies: transaction accounting advice.
The Commission should also ask the
auditor to report on its audit of • If no external audit of internal
management’s assessment and control PCAOB to provide additional guidance
control is required, guidance on how
effectiveness. As the COSO Framework to help clarify and encourage greater
management, in general, can assess
is currently the most widely used cost-effectiveness in the application of
internal controls efficiently and on a
internal control framework in the U.S., AS2. The Commission should, for
stand-alone (i.e., no external auditor
managements and auditors have used it example, ask the PCAOB to reinforce
involvement) basis; 104 and
and re-emphasize (including through
to assess internal control. Based on the • If ASX is required, guidance on
input provided by COSO on its the inspection process 105) the helpful
how management, in general, can assess
framework, we have concluded that points made in the PCAOB’s May 16
internal controls efficiently and in
clear guidance does not yet exist for guidance 106 and its November 30, 2005
satisfaction of the requirements of the
smaller public company managers on report,107 including, in particular, the
external auditor acting under ASX
how to support a proper Section 404 following:
without following the auditor-directed • A risk-based approach is needed;
assessment of internal control absent guidance in ASX or AS2. • Controls should provide
AS2. The PCAOB in its January 17, 2006 management with reasonable assurance,
While COSO has proposed additional comment letter to COSO recommended not absolute or perfect certainty;
guidance for smaller companies, there is that COSO reconsider whether there is • ‘‘More than remote’’ means
currently little practical guidance additional, more practical guidance that ‘‘reasonably possible’’ ;
available to assist smaller companies in COSO could provide to smaller public • Control testing is to find material
implementing the COSO Framework in companies. We support this goal and weaknesses, and other testing should be
a cost-effective manner. AS2 provides consider such practical guidance as scaled back (i.e. testing is not to find
guidance for an auditor to assess critical to smaller public companies deficiencies and significant
internal control effectiveness. It was not having a cost-effective approach to deficiencies);
intended to provide management assessing their internal controls. • The financial and internal control
guidance. As a practical matter, We believe that the Commission also audits should be integrated (especially
however, because AS2 provides detailed should assess, in light of, among other at smaller companies);
guidance for assessing internal control, factors, existing and suggested guidance, • All restatements should not be
it is by default the standard that when it would be advisable to treated as material weaknesses because
management uses. We do not think that reevaluate and consider amending AS2. accounting complexity not control
COSO’s revised guidance for smaller Furthermore, the Commission should deficiencies are at the root of many
companies will result in a cost effective provide additional guidance by restatements; and
or proportional alternative for clarifying considerations, and • Management’s consultation with
implementing Section 404. encouraging cost-effectiveness, relating the external auditor regarding the
The Commission should ask COSO to to management’s design and assessment
provide additional guidance to help of internal controls and by developing 105 See Conference Panelists Discuss Earnings
management of smaller companies resources to enhance the availability of Guidance and Accounting Issues, SEC Today (Feb.
assess internal controls because of the additional guidance. 14, 2006), at 2 (quoting Teresa Iannaconi as stating
lack of practical guidance and the that while she believes the PCAOB is sincere in its
In order to provide this clarification attempt to bring greater efficiency to the audit
absence of a standard to enable and encouragement, the Commission process, accounting firms are not ready to ‘‘step
management of smaller companies to could, for example, back,’’ because they have all received deficiency
address internal control. letters, none of which say that the auditors should
• State that ‘‘materiality’’ for the be doing less rather than more).
The Commission could, for example,
purposes of assessing a ‘‘material 106 PCAOB Release No. 2005–009, Policy
ask COSO to:
weakness’’ under Section 404 is to be Statement Regarding Implementation of Auditing
• Add post-year one monitoring Standard No. 2, an Audit of Internal Control Over
determined on an annual but not on a
guidance with selective testing where
Financial Reporting Performed in Conjunction with

quarterly basis;
appropriate (in this regard, we note that an Audit of Financial Statements (May 16, 2005).
107 PCAOB Release No. 2005–023, Report on the
the PCAOB, in its January 17, 2006 104 While AS2 provides a way to assess internal Initial Implementation of Auditing Standard No. 2,
comment letter to COSO, noted that controls, it is designed for external auditors rather An Audit of Internal Control Over Financial
‘‘auditability should not be the primary than management and has not proven to be a cost- Reporting Performed in Conjunction with an Audit
goal of the guidance.’’); and effective tool in regard to smaller companies. of Financial Statements (Nov. 30, 2005).
proper accounting for a transaction mindshare that has been diverted from received generally supported this
should not lead the auditor conclude a operating and growing their businesses. conclusion. We did identify some areas,
material weakness exists. The proportionately larger costs for however, where we believe changes in
In addition, the Commission could smaller public companies to comply regulation could be made that would
ask the PCAOB to: with Section 404 may not generate reduce compliance costs without
• State that materiality for the commensurate benefits, adversely compromising investor protection.
purposes of assessing a ‘‘material affecting their ability to compete with In terms of capital formation matters,
weakness’’ under Section 404 should be larger U.S. public companies, U.S. we heard ample testimony and reviewed
determined on an annual rather than private companies and foreign a significant amount of data regarding
quarterly basis; competitors. Smaller companies would the disproportionate burden that the
• Describe ways to reduce have to allocate their limited resources Sarbanes-Oxley Act, particularly
compliance costs relating to information toward Section 404 compliance even Section 404, imposes on smaller
technology controls, a significant source though the required control processes companies. In terms of capital
of internal control compliance costs, may not add significant value to their formation, we believe that the increased
consistent with the underlying risks; financial statements. If their ability to burden brought about by
and compete is diminished, these smaller implementation of Section 404 and
• Consider and publicize additional U.S. companies may find it more other regulatory measures have had a
ways to reduce the complexity of AS2 difficult to raise capital to engage in significant effect on both the nature of
as currently being implemented. value-producing investments. the relationship between private and
Recommendation III.S.2 The significant, disproportionate public capital markets and on the
compliance burden placed on the attractiveness of the U.S. capital markets
Determine the necessary structure for shareholders of smaller public in relation to their foreign counterparts.
COSO to strengthen it in light of its role companies has had a negative effect on In our view, public companies today
in the standard-setting process in their ability to compete with their larger must be more mature 108 and
internal control reporting. U.S. public company competitors, and, sophisticated, have a more substantial
COSO has been placed in an elevated to an even greater extent, their foreign administrative infrastructure and
role by virtue of being referenced in AS2 competitors. This reduction in the expend substantially more resources
and the Commission’s release adopting competitiveness of U.S. smaller public simply to comply with the increased
the Section 404 rules. While the rules companies will hurt their capital securities regulatory burden.
do not require the use of the COSO formation ability and, as a result, hurt Additionally, the liquidity demands of
Framework in performing Section 404 the U.S. economy. Smaller companies institutional investors, the consolidation
assessments, COSO is by far the most have limited resources, which are being of the underwriting industry and the
widely used internal control framework allocated unnecessarily to internal increased cost of going public have
for such purposes. processes for Section 404 compliance. dictated that companies be larger,109
In addition, COSO has issued Since these processes play less of a role and effect larger transactions, in order to
preliminary guidance for smaller public in the preparation of financial undertake an initial public offering.
companies. As a result, COSO has statements for smaller companies, this Stated simply, we believe that it is today
become a de facto standard setting body effort results in diminished shareholder far more difficult and expensive to go—
for preparers of financial statements value that makes these companies less and to remain—public than just a
though it is not recognized as an official attractive investments and, thereby, decade ago, and as a consequence,
standard setter, nor is it funded and harms their capital formation ability. companies are increasingly turning to
structured as one. The major drivers of the the private capital markets to satisfy
The Commission, in conjunction with disproportionate burden are that smaller their capital needs.
other interested bodies, as appropriate, companies lack the scale to cost- In light of the continued importance
should determine the necessary effectively implement standards of the private markets, and our
structure for COSO, including a broader designed for large enterprises and that perception that most of the more
member constituency, to strengthen it in there are no guides available for obvious regulatory impediments to the
light of its important role in establishing management on how to make its own efficient formation of capital lie in the
and providing guidance with respect to independent Section 404 assessment or private realm, we are making a number
the internal control framework used by for auditors on how to ‘‘right-size AS2’’ of recommendations that we believe
most companies and auditors to for smaller companies. will improve the ability of private
evaluate the effectiveness of internal The ‘‘cost/benefit’’ challenge is being companies to efficiently reach and
control over financial reporting. raised by companies of all sizes, but communicate with investors, while
* * * * * most acutely by smaller companies on continuing to protect those investors
We fully agree with the goals of recent which the burden of cost, time and most in need of the protections afforded
regulatory reforms, including the mindshare diversion fall most heavily. by registration under the Securities Act.
Sarbanes-Oxley Act, and believe that In terms of the public markets, there
they have helped to improve corporate Part IV. Capital Formation, Corporate
is a concern that U.S. markets may
governance and restore investor Governance and Disclosure
confidence. These include reforms We have conducted a full review of 108 With respect to venture-backed startups, the
relating to board independence, corporate governance and disclosure average time from initial venture financing to initial
management certifications and requirements applicable to smaller public offering has increased from less than three
years in 1998 to more than five and a half years
whistleblower programs. We disagree public companies. We concluded that, today. Rebecca Buckman, Tougher Venture: IPO
strongly, however, with the assertion in general, aside from the significant
Obstacles Hinder Start-ups, Wall St. J., Jan. 25,

that Section 404, as currently being regulatory scaling deficiencies outlined 2006, at C1.
109 The median stock market value of a venture-
implemented, is worth the significant above, the current securities regulatory
backed company going public last was $216
‘‘tax’’ it has placed on American system for smaller public companies million, a marked increase from the $138 million
business, in terms of dollars spent, time works well to protect investors. The oral median value in 1997 and the just under $80
committed, and organizational testimony and written statements we million median value in 1992. Id. at 3.
become increasingly less attractive for are recommending that the Commission Listed below are the primary
companies wishing to raise capital. The cease prescribing separate disclosure disclosure accommodations currently
U.S. percentage of all money raised from Forms 10–KSB, 10–QSB, 10–SB, SB–1 available to small business issuers
foreign companies undertaking a new and SB–2 for smaller companies. All under Regulation S–B. We are
stock offering declined from 90% of all public companies would then use the recommending that all of these be
such money raised in 2000 to less than same set of forms, such as Forms 10–K, integrated into Regulation S–K and be
ten percent in 2005.110 10–Q, 10, S–1 and S–3. made available to all microcap
To address these issues, and to As discussed briefly above, companies. Microcap companies would
promote healthier and more robust Regulation S–B was adopted by the have the option of following the
capital markets, will require removing Commission in 1992 as an integrated disclosure requirements for larger
duplicative regulation, enhancing registration and reporting system companies if they chose to do so.
disclosure and promoting an improved covering both disclosure and financial • Under Item 101 of Regulation S–B,
atmosphere for independent analyst statement rules for ‘‘small business small business issuers are required to
coverage of smaller public companies. issuers.’’ 111 ‘‘Small business issuer’’ is provide a less detailed description of
defined as an issuer that with both their business and to disclose business
Capital Formation, Corporate revenues and a public float of less than development activities for only three
Governance and Disclosure—Primary $25 million.112 The system provides years, instead of the five years required
Recommendations specialized forms under the Securities of larger companies by Regulation S–K.
We recommend that the Commission and Exchange Acts with disclosure and • Regulation S–B currently does not
and other bodies, as applicable, financial statement requirements that include an Item 301 (selected financial
effectuate the following: are somewhat less rigorous than the data) or Item 302 (supplementary
requirements applicable to larger financial information), which are
Recommendation IV.P.1
companies under Regulation S–K, the included in Regulation S–K, meaning
Incorporate the scaled disclosure integrated disclosure system, and that small business issuers are not
accommodations currently available to Regulation S–X, the integrated financial required to disclose this information.
small business issuers under Regulation statement system, for larger • Regulation S–B provides for more
S–B into Regulation S–K, make them companies.113 streamlined disclosure for
available to all microcap companies, We reviewed the benefits and management’s discussion and analysis
and cease prescribing separate drawbacks of Regulation S–B and of financial condition and results of
specialized disclosure forms for smaller considered whether the operations by requiring only two years
companies. accommodations in Regulation S–B of analysis if the company is presenting
As discussed above, we are should be expanded, contracted, or only two years of financial statements,
recommending that the Commission extended to a broader range of smaller instead of the three years required of
establish a new system of scaled or public companies. We considered oral companies that present three years of
proportional securities regulation for and written testimony as to the benefits financial statements, as required under
smaller public companies that would and limitations of Regulation S–B, Regulation S–K.115
replace Regulation S–B and make scaled including testimony and discussion • Regulation S–B does not require
regulation available to a much larger during a joint meeting with the smaller companies to provide a tabular
group of smaller public companies. We Commission’s annual Forum on Small disclosure of contractual obligations as
are not recommending, however, that Business Capital Formation.114 larger companies must do under Item
the scaled disclosure accommodations 303(a)(5) of Regulation S–K.116
now available to small business issuers 111 Small Business Initiatives, SEC Release No.
• Regulation S–B does not require
under Regulation S–B be discarded. 33–6949 (July 30, 1992) [57 FR 36442]. Regulation
S–B is codified at 17 CFR 228.10 et seq. small business issuer filings to contain
Instead, we are recommending that they 112 In addition, small business issuers must be quantitative and qualitative disclosure
be integrated into Regulation S–K and U.S. or Canadian companies, cannot be investment about market risk section as required of
made available to all microcap companies or asset-backed issuers and cannot be larger companies under Item 305 of
companies, defined as we recommend majority owned subsidiaries of companies that are
Regulation S–K.117
under ‘‘Part II. Scaling Securities not small business issuers. 17 CFR 228.10(a)(1).
113 Regulation S–K is codified at 17 CFR 229.10
Regulation for Smaller Companies.’’ In et seq. Regulation S–X, which provides accounting 265–23/bdoseidman053105.pdf; Letter from
Recommendation IV.P.2 immediately rules for larger companies, is codified at 17 CFR Stephen M. Brock (May 31, 2005), available at
below, we recommend that all scaled 210.01.01 et seq. The accounting rules for small http://www.sec.gov/rules/other/265–23/
business issuers using Regulation S–B generally are smbrock1317.pdf; Letter from Ernst & Young (May
financial statement accommodations 31, 2005), available at http://www.sec.gov/rules/
contained in Item 310 of Regulation S–B, 17 CFR
now available to small business issuers 228.310. other/265–23/ey053105.pdf; Letter from Small
under Regulation S–B be made available 114 See Record of Proceedings 48, 143, 148 (June Business & Entrepreneurship Council to Committee
to all smaller public companies, defined 17, 2005) (testimony of William A. Loving, David (May 31, 2005), available at http://www.sec.gov/
rules/other/265–23/kkerrigan8306.pdf; Letter from
as we recommend under ‘‘Part II. N. Feldman and John P. O’Shea. See also Letter
Society of Corporate Secretaries & Governance
Scaling Securities Regulation for from Brad Smith to Committee (May 24, 2005) (on
file in SEC Public Reference Room), available at Professionals (June 7, 2005), available at http://
Smaller Companies.’’ In addition, we http://www.sec.gov/rules/other/265–23/ www.sec.gov/rules/other/265–23/sspc-slc-
bsmith2573.htm; Letter from Kathryn Burns to scsgp060705.pdf; Letter from Mark B. Barnes to
110 G. Karmin and A. Luchetti, New York Loses Committee (May 24, 2005), available at http:// Committee (August 2, 2005), available at http://
Edge in Snagging Foreign Listings, Wall St. J., Jan. www.sec.gov/rules/other/265–23/kburns052405.pdf; www.sec.gov/rules/other/265–23/
26, 2006, at C1 (‘‘[Undertaking an offering outside Letter from David N. Feldman to Committee (May mbbarnes080205.pdf; and Letter from Gregory C.
the U.S.] would have been an unusual move as 30, 2005, available at http://www.sec.gov/rules/ Yardley, Jean Harris, Stanley Keller, A. John
recently as 2000, when nine out of every 10 dollars other/265–23/dnfeldman053005.htm; Letter from Murphy, and A. Yvonne Walker to Committee
(Sept. 12, 2005), available at http://www.sec.gov/
raised by foreign companies through new stock Michael T. Williams to Committee (May 30, 2005),
offerings were done in New York rather than available at http://www.sec.gov/rules/other/265–23/ rules/other/265–23/gcyadley091205.pdf.
115 MD&A requirements are found in Item 303 of
London or Luxembourg * * * But by 2005, the mtwilliams6614.pdf; Letter from KPMG to
reverse was true: Nine of every 10 dollars were Committee (May 31, 2005), available at http:// both Regulation S–K and Regulation S–B, 17 CFR
raised through new company listings in London or www.sec.gov/rules/other/265–23/kpmg053105.pdf; 229.303 & 17 CFR 228.303.
116 17 CFR 229.303(a)(5).
Luxembourg, the biggest spread favoring London Letter from BDO Seidman to Committee (May 31,
since 1990.’’). 2005), available at http://www.sec.gov/rules/other/ 117 17 CFR 229.305.
• Under Item 402 of Regulation S–B, In summary, we believe that advantage of financial statement
small business issuers currently are not incorporating the disclosure accommodations now available only to
required to include a compensation accommodations currently available to small business issuers.
committee report or a stock performance small business issuers under Regulation The primary financial statement
graph in their executive compensation S–B into Regulation S–K, rather than accommodation now afforded to small
disclosures, as larger companies are retaining them in a separate but similar business issuers is provided under Item
required to do under Item 402 of and parallel system, will result in many 310 of Regulation S–B. That provision
Regulation S–K.118 benefits. Among them, any stigma permits small business issuers to file
We have numerous reasons for associated with taking advantage of the two years of audited income statements,
recommending the abandonment of accommodations would be lessened. In cash flows, and changes in stockholders
Regulation S–B as a separate, stand addition, this would reduce the equity and one year of audited balance
alone integrated disclosure system, complexity of SEC rules, in keeping sheet data in annual reports and
including the abandonment of separate with the overarching goal expressed in registration statements. Larger public
prescribed forms for small business our Committee Agenda of ‘‘keeping companies are required to file three
issuers. The drawbacks associated with things simple.’’ years of audited income statement and
Regulation S–B include a lack of
Recommendation IV.P.2 other data and two years of audited
acceptance of ‘‘S–B filers’’ in the
Incorporate the primary scaled balance sheet data under Regulation
marketplace, a possible stigma
financial statement accommodations S–X.121 We recommend that smaller
associated with being an S–B filer, and
currently available to small business public companies be required to file
the complexity for the SEC and public
issuers under Regulation S–B into only two years of audited income
companies and their counsel of
Regulation S–K or Regulation S–X and statements, cash flows, and changes in
maintaining and staying abreast of two
make them available to all microcap and stockholders equity but two years of
sets of disclosure rules that are
smallcap companies. audited balance sheet data in annual
substantially similar. Further, we
As discussed above, we are reports and registration statements.
received input that many securities
lawyers saying they are not familiar recommending that the Commission We believe that requiring a second
with Regulation S–B and therefore are establish a new system of scaled or year of audited balance sheet data for
hesitant to recommend that their clients proportional securities regulation for smaller public companies provides
use this alternative disclosure smaller public companies that would investors with a basis for comparison
system.119 replace Regulation S–B. In with the current period, without
We heard numerous comments to the Recommendation IV.P.1 immediately substantially increasing audit costs. On
effect that the thresholds for using above, we recommend that the the other hand, we believe that
Regulation S–B are too low and should disclosure accommodations currently eliminating the third year of audited
be increased to permit a broader range available to small business issuers income statement, cash flow and
of smaller public companies to be under Regulation S–B be made available changes in stockholders equity data for
eligible for its benefits, particularly in to all microcap companies, as we have smaller public companies will reduce
light of the increased costs associated recommended that term be defined in costs and simplify disclosure while not
with reporting obligations under the ‘‘Part II. Scaling Securities Regulation adversely impacting investor protection
Exchange Act since passage of the for Smaller Companies’’ above. In this in any significant way. Third year data
Sarbanes-Oxley Act.120 recommendation, we recommend that and corresponding analysis is generally
the primary financial statement less relevant to investors than the more
118 Executive compensation disclosure accommodations currently afforded to current data and third year data is often
requirements are found in Item 402 of both small business issuers under Regulation readily obtainable online.122 If the
Regulation S–K and Regulation S–B, 17 CFR S–B be made available to all ‘‘smaller company has been a reporting company
228.402 and 17 CFR 229.402. The Commission public companies’’ as we have
recently proposed major amendments to the for three years, the third year data
executive compensation disclosure rules under both recommended that term be defined should be readily accessible through the
Regulation S–B and Regulation S–K. See Executive above. Adopting this recommendation Commission’s EDGAR system and other
Compensation and Related Party Disclosure, SEC would mean that both microcap sources. Investors today have access to
Release No. 33–8655 (Jan. 27, 2006) [71 FR 6541]. companies and smallcap companies, as
We recommend that the Commission apply numerous years of financial information
whatever executive compensation disclosure rules we would have the Commission define about any reporting company because of
ultimately are adopted for smaller issuers to those terms, would be entitled to take the significant technological advances
microcap companies as we propose to define that
term rather than only to small business issuers as
in obtaining financial information about
265–23/bdoseidman053105.pdf; Letter from
currently defined under Regulation S–B. Stephen M. Brock to Committee (May 31, 2005),
reporting issuers. We do not believe that
119 See Record of Proceedings 48, 143, 148 (June
available at http://www.sec.gov/rules/other/265–23/ investors will be harmed in any
17, 2005) (testimony of William A. Loving, David smbrock1317.pdf; Letter from Ernst & Young to significant way if the Commission
N. Feldman and John P. O’Shea). Committee (May 31, 2005), available at http:// adopts this recommendation.
120 See Letter from Brad Smith to Committee (May www.sec.gov/rules/other/265–23/ey053105.pdf;
24, 2005) available at http://www.sec.gov/rules/ Letter from Small Business & Entrepreneurship
121 17 CFR 210.1–01 et seq. The financial
other/265–23/bsmith2573.htm); Letter from Kathryn Council to Committee (May 31, 2005), available at
Burns to Committee (May 24, 2005), available at http://www.sec.gov/rules/other/265–23/ statement rules applicable to small business issuers
http://www.sec.gov/rules/other/265–23/ kkerrigan8306.pdf; Letter from Society of Corporate appear in Item 310 as part of Regulation S–B,
kburns052405.pdf; Letter from David N. Feldman to Secretaries & Governance Professionals to whereas the financial statement rules applicable to
Committee (May 30, 2005) available at http:// Committee (June 7, 2005), available at http:// larger companies appear in Regulation S–X, an
www.sec.gov/rules/other/265–23/ www.sec.gov/rules/other/265–23/sspc-slc- entirely separate regulation. We take no position on
dnfeldman053005.htm; Letter from Michael T. scsgp060705.pdf; Letter from Mark B. Barnes to whether the financial statement rules that would
Williams to Committee (May 30, 2005), available at Committee (Aug. 2, 2005). available at http:// apply to all smaller public companies under our
http://www.sec.gov/rules/other/265–23/ www.sec.gov/rules/other/265–23/ recommendation should appear in Regulation S–K
mtwilliams6614.pdf; Letter from KPMG to mbbarnes080205.pdf; and Letter from Gregory C. as a separate set of rules applicable to all smaller
Committee (May 31, 2005), available at http:// Yardley, Jean Harris, Stanley Keller, A. John public companies, or in Regulation S–X.
www.sec.gov/rules/other/265–23/kpmg053105.pdf; Murphy, and A. Yvonne Walker to Committee 122 See Internet Availability of Proxy Materials,
Letter from BDO Seidman to Committee (May 31, (Sept. 12, 2005), available at http://www.sec.gov/ SEC Release No. 34–52926 (Dec. 15, 2005) [70 FR
2005), available at http://www.sec.gov/rules/other/ rules/other/265–23/gcyadley091205.pdf. 74598].
Moreover, we believe that eliminating • Small business issuers need not Counter Bulletin Board (‘‘OTCBB’’) 125
the third year of income statement, cash provide financial statements of to file reports under the Exchange Act.
flow and stockholders equity data for significant equity investees, as required Under Exchange Act rules, registrants
smaller public companies will reduce by Rule 3–09 of Regulation S–X, in any must file annual and quarterly reports
costs and simplify disclosure. document filed with the SEC. disclosing information about their
Eliminating the third year of audited Small business issuers domiciled in companies. Registrants also have an
income statement and other data may Canada may present their financial obligation to file current reports when
serve to reduce costs associated with statements in accordance with Canadian certain events occur. All reporting
changing audit firms by eliminating GAAP and reconcile those financial companies have the same disclosure
certain of the expenses and processes statements to U.S. GAAP. Any non- obligations as the largest of public
associated with predecessor auditor small business issuer filing a companies. And, in order to take
consent requirements. An issuer’s prior registration statement on a domestic advantage of the Section 404 exemptive
auditors must execute consents in order form, such as Form S–1, S–3 or S–4, relief we are recommending for
for financial statements previously must present its financial statements in microcap companies, all those reporting
audited by that firm to be included in accordance with U.S. GAAP and companies included in the Pink Sheets
SEC reports and registration statements. provide all disclosures required under would need to be current in their SEC
Adopting this recommendation may U.S. GAAP. periodic reporting obligations. Their
make it easier for smaller public Recommendation IV.P.3 disclosure should be sufficient to
companies to change their auditors, protect investors and inform the
thereby increasing competition among Allow all reporting companies on a marketplace about developments in
auditing firms. national securities exchange, NASDAQ these companies. As online accessibility
or the OTCBB to be eligible to use Form to previously filed documents on
In addition, we believe that the
S–3, if they have been reporting under
following financial statement corporate and other Web sites, including
the Exchange Act for at least one year
accommodations currently provided to the SEC’s EDGAR Web site, increases;
and are current in their reporting at the
small business issuers would be smaller public companies should be
time of filing.
afforded to all smaller public companies Form S–3 is a short-form registration permitted to take advantage of the
if this recommendation is adopted: statement under the Securities Act that efficiency and cost savings of
• In an initial public offering, small allows companies eligible to use it incorporation by reference to
business issuers have a longer period of maximum use of incorporation by information already on file. The
time in which they do not have to reference to information previously filed Commission has recently taken several
provide updated audited financial with the Commission.124 As discussed steps acknowledging the widespread
statements in their registration below, we recommend that the accessibility over the Internet of
statements. For example, for non-small efficiencies associated with the use of documents filed with the SEC. In its
business issuers, if the effective date of Form S–3 be made available to all recent release concerning Internet
the registration statement for the initial companies that have been reporting delivery of proxy materials,126 the
public offering falls after 45 days of the under the Exchange Act for at least one Commission noted that recent data
end of the issuer’s fiscal year, the non- year, and are current in their Exchange indicates that up to 75% of Americans
small business issuer must provide Act reporting at the time of filing. have access to the Internet in their
audited financial statements in their Additionally, we recommend homes, and that this percentage is
registration statement for the most elimination of the current condition to increasing steadily among all age
recently completed year, with no the use of Form S–3 that the issuer has groups. As a result, we believe that
exceptions. For small business issuers, timely filed all required reports in the investor protection would not be
if the effective date of the registration last year. materially diminished if all reporting
statement falls after 45 days but within Current SEC rules allow issuers with companies on a national securities
90 days of the end of the small business over $75 million in public float to use exchange, NASDAQ or the OTCBB were
issuer’s fiscal year, the small business Form S–3 in primary offerings. permitted to utilize Form S–3 and the
issuer is not required to provide the Additionally, Form S–3 may be used for associated benefits of incorporation by
audited financial statements for such secondary offerings for the account of reference. Further, the smaller public
year end, provided that the small any person other than the issuer if companies that would be newly entitled
business issuer has reported income for securities of the same class are listed to use Form S–3 if this recommendation
at least one of the two previous years and registered on a national securities is adopted would not enjoy the
and expects to report income for the exchange or are quoted on NASDAQ. automatic effectiveness of registration
recently-completed year.123 Many smaller public companies are not statements, as is the case with well
• Issuers filing a registration eligible to use Form S–3 in primary known seasoned issuers under the SEC’s
statement under the Exchange Act offerings because their public float is recent Securities Act Reform rules.127
(which is currently filed on Form 10–SB below $75 million; they also cannot use Accordingly, the SEC staff can elect to
but would be filed on Form 10 if our Form S–3 in secondary offerings review the registration statement and
previous recommendation is adopted) because their securities are not listed on documents of smaller public companies
need not audit the financial statements a national securities exchange or quoted
for the previous year if those financial on NASDAQ.
125 The OTCBB is a regulated quotation service
statements have not been audited that displays real-time quotes, last-sale prices, and
Since 1999, the NASD has required volume information in over-the-counter (OTC)
previously. This also applies to any companies traded on its Over-the- equity securities. An OTC equity security generally
financial statements of recently acquired
is any equity security that is not listed or traded on

businesses or pending acquisitions that 124 Form S–3 can be found at 2 Fed. Sec. L. Rep. NASDAQ or a national securities exchange.
126 See Internet Availability of Proxy Materials,
are included in an Exchange Act (CCH) ¶ 7151. Form S–3 was originally adopted in
Revisions of Certain Exemptions from Registration SEC Release No. 34–52926 (Dec. 15, 2005) [70 FR
registration statement. 74598].
for Transactions Involving Limited Offers and Sales,
SEC Release No. 33–6383 (Mar. 3, 1982) [47 FR 127 See Securities Offering Reform, SEC Release
123 See 17 CFR 228.310(g)(2). 11380]. No. 33–8591 (July 19, 2005) [70 FR 44722].
incorporated by reference if it chooses the securities of OTCBB issuers. As a companies in particular, has declined
to do so. Additionally, the Sarbanes- consequence, OTCBB issuers that dramatically in recent years, however,
Oxley Act has required more frequent undertake private placements with as economic and regulatory pressures
SEC review of periodic reports as well associated registration rights, or that are have led the financial industry to
as enhanced processes, such as required to register affiliate or Rule 145 dramatically reduce research budgets.131
disclosure controls and procedures and shares, are required to file a registration The problem is particularly pronounced
certifications by the chief executive and statement on Form S–1 or Form SB–2 in the case of smallcap companies, of
chief financial officers, which further and incur the substantial burden and which less than half receive coverage by
enhances investor protection. We expense that the continuous updating of even a single analyst, and in the
believe the adoption of this those forms require. microcap universe, where analyst
recommendation will also facilitate When the Commission adopted Form coverage is virtually non-existent.132
capital formation by reducing costs of S–3 in 1982, the distinction drawn The existing regulatory framework
smaller public companies and providing between OTCBB and exchange and and business environment exacerbates
more rapid access to the capital markets. NASDAQ-traded securities was logical. this problem, and commission rates
We further recommend that OTCBB issuers were not at the time have declined for firms that historically
corresponding changes be made to other required to file Exchange Act reports used these revenue streams to fund
forms providing similar streamlined with the SEC. In 1999, however, the research. Business models have emerged
disclosure for S–3 eligible issuers, such NASD promulgated new eligibility rules to create published research in order to
as Form S–4. that required all issuers of securities fill the resulting void, although their
We acknowledge that some members quoted on the OTCBB to become SEC involvement with independent research
of the public may believe that reporting companies and be current in providers that also participate in the
recommending Form S–3 eligibility for its Exchange Act filings, making the global settlement agreement has until
all reporting companies is contrary to need for such a distinction less recently been uncertain.133
our recommendation seeking relief from apparent.129
Sarbanes-Oxley Act Section 404 but we We concur with the Commission’s 131 A recent article notes, for instance, that fewer
believe strongly that all reporting original analysis in 1982 that ‘‘most companies are receiving analyst coverage today
secondary offerings are more in the than at any time since 1995. Where’s the Coverage?,
companies should have the same CFO Magazine (Jan. 20, 2005), available at http://
efficient access to the market as large nature of ordinary market transactions www.cfo.com/article.cfm/3516678/
reporting companies. Microcap than primary offerings by the registrant, c_3576955?f=home_todayinfinance.
companies have the same reporting and, thus, that Exchange Act reports 132 Testimony provided to the Committee
obligations as the largest of reporting may be relied upon to provide the indicated that approximately 1,200 of the 3,200
NASDAQ-listed companies, and 35% of all public
companies and should not be penalized marketplace information needed companies, receive no analyst coverage at all. See
because of size. The changes in respecting the registrant.’’ 130 In light of Record of Proceedings 17 (June 17, 2005) (testimony
reporting requirements of microcap the current requirement that OTCBB of Ed Knight, Vice President and General Counsel
companies on the OTCBB support this issuers also be SEC reporting of NASDAQ). Statistics provided by the SEC Office
of Economic Analysis indicate that in 2004
recommendation. companies, we believe that extending approximately 52% of companies with a market
We recommend that the Commission Form S–3 eligibility for secondary capitalization between $125 million and $750
eliminate the requirement that the transactions to OTCBB issuers is million and 83% of companies with a market
registrant has filed in a timely manner consistent with the rationale underlying capitalization less than $125 million had no analyst
all reports required to be filed during coverage.
Form S–3 at the time of its adoption. 133 In the course of the Advisory Committee’s
the preceding 12 calendar months as a Moreover, allowing such use of Form S– proceedings, we were made aware of one informal
condition to the use of Form S–3, if the 3 would benefit OTCBB issuers by (1) clarification regarding administration of the global
issuer has been reporting under the eliminating unnecessary, duplicative settlement agreement in the recent analyst coverage
Exchange Act for at least 12 months disclosure while ensuring that security enforcement cases that will likely have a beneficial
and, at the time of such filing, has filed effect on the availability of independent research.
holders, investors and the marketplace As members of the Commission are aware, one
all required reports. We believe that the are provided with the necessary aspect of the global settlement agreement provides
risk of SEC enforcement action, information upon which to base an that, for a period of five years commencing in 2004,
delisting notifications and investment decision and (2) investment banks that are parties to the settlement
accompanying disclosure, and are required to provide to their U.S. customers
substantially reducing the costs independent research reports alongside their own
associated negative market reactions are associated with undertaking a private research reports on certain companies that their
sufficient and more appropriate financing. analysts cover. Entities that provide independent
deterrents to late filings, and depriving research reports to the settling banks (‘‘independent
late filers of an efficient means to access Recommendation IV.P.4 research providers’’ or ‘‘IRPs’’) cannot also conduct
‘‘paid-for’’ research, i.e., research done on behalf of,
the capital markets is unduly Adopt policies that encourage and and paid for by, individual companies. Because
burdensome to issuers, both large and promote the dissemination of research many IRPs do not want to be excluded from
small.128 on smaller public companies. participating in the global settlement, the effect of
General Instructions to Form S–3 The trading markets for public this prohibition—at least in the view of some—was
limit the use of that form for secondary to limit the number of entities willing to undertake
companies are assisted in great measure paid-for research on behalf of individual
offerings to securities ‘‘listed and by the dissemination of quality companies.
registered on a national securities investment research. Investment In October 2005, the five regulators overseeing
exchange or * * * quoted on the research coverage for public companies implementation of the global settlement informed
automated quotation system of a the independent consultants (essentially the
in general, and for smaller public persons responsible for procuring the independent
national securities association,’’ a research under the settlement) of how the
restriction that by definition excludes
129 Press Release, NASD, NASD Announces SEC

settlement applies to independent research
Approval of OTC Bulletin Board Eligibility Rule intermediaries that match companies and IRPs on
128 To prevent issuers from taking advantage of (Jan. 6, 1999). a ‘‘blind pool’’ basis (i.e., a complete wall is
130 See Revisions of Certain Exemptions from maintained between the entity that purchases the
the system by, for instance, becoming current on
day one and filing a Form S–3 on day two, the Registration for Transactions Involving Limited research, most likely the company being analyzed,
Commission could require that the issuer be current Offers and Sales, SEC Release No. 33–6383, at 10 and the selection of an IRP to conduct the research).
for at least 30 days before filing a Form S–3. (Mar. 3, 1982) [47 FR 11380]. Although no formal pronouncement was issued,
A lack of independent analyst commissions to pay for research prohibits issuers from taking advantage
coverage has several adverse effects, services) under the safe harbor of the tremendous efficiencies and reach
both for individual companies and for provisions of current Exchange Act of the Internet to communicate with
the capital markets as a whole: Section 28(e), as amplified by guidance potential investors who do not need all
• Companies with no independent set forth in SEC Release No. 34–52635. the protections of the Securities Act’s
analyst coverage have a reduced market We acknowledge that these two registration requirements. In our view,
capitalization in comparison with recommendations do not request this is a significant impediment to the
companies that do have such coverage, significant changes in existing SEC efficient formation of capital for smaller
and are subject to higher financing costs policies, but rather, call for more or less companies, one that could easily be
when compared with their analyst- continuation of existing policies. corrected by modernizing the existing
covered peers; 134 Despite a shared conviction that prohibitions on advertising and general
• A lack of coverage by independent independent analyst coverage is critical solicitation.
analysts limits shareholders’ and to the success of smaller public Traditionally, both federal and state
prospective shareholders’ ability to companies and to the efficient operation private offering exemptions have been
obtain an informed outsider’s of our capital markets, we were unable conditioned on the absence of
perspective on identifying strengths and to identify specify regulatory ‘‘advertising or general solicitation.’’
weaknesses and areas for improvement; impediments that could be modified in These concepts and SEC interpretations
• The lack of coverage lessens the a manner that would be consistent with have not provided bright-line objective
entire ‘‘mix of information’’ made the Commission’s investor protection criteria for issuers and their advisers.
available to investment bankers, fund mandate. We nonetheless have included Nevertheless, when it comes to exempt
managers and individual investors, these two recommendations in order to transactions, issuers face draconian
which make markets less efficient; and highlight for the Commission the risks to the viability of the entire
• Because analyst reports trigger the existing problem, to ask that existing offering for non-compliance with just
buying and selling of shares, the lack of policies be maintained and to request one of the many required exemption
such reports frustrates the formation of that the Commission continue to search elements. For example, even if all
a robust trading market.135 for new ways to promote analyst purchasers (A) are accredited investors,
In order to address the need for more coverage for smaller public companies. (B) have pre-existing business
independent research for smaller public relationships with the issuing company
companies, we recommend that the Recommendation IV.P.5 and (C) are contacted in face-to-face
Commission: Adopt a new private offering meetings, some case law supports the
• Maintain policies that allow exemption from the registration view that the exemption will
company-sponsored research to occur requirements of the Securities Act that nevertheless be lost for the entire
with full disclosure by the research does not prohibit general solicitation offering if other issuer activities are
provider as to the nature of the and advertising for transactions with found to have involved general
relationship with the company being purchasers who do not need all the solicitation or advertising. This could
covered. Entities providing such protections of the Securities Act’s occur, for example, if the issuer made
research should disclose and adhere to registration requirements. Additionally, offers at a social function to 50
a set of ethical standards that ensure relax prohibitions against general prospective purchasers, all of whom
quality and transparency and minimize solicitation and advertising found in were social friends of the issuing
conflicts of interest.136 Rule 502(c) under the Securities Act to company’s principals but with whom
• Continue to permit ‘‘soft dollar’’ the company did not enjoy pre-existing
parallel the ‘‘test the waters’’ model of
payments (i.e., the use of client business relationships. A similar
Rule 254 under that Act.
The ban on general solicitation and adverse result could occur if the issuer
regulators responsible for the enforcement of the
global settlement told the independent consultants
advertising in connection with exempt or an agent of the issuer placed an
that they have the discretion to decide whether or private offerings dates back to some of advertisement on a local cable TV show,
not to procure independent research from IRPs that the earliest SEC staff interpretations of Internet web page or newspaper that
also contract with independent research the Securities Act.137 Although the featured the issuer’s capital formation
intermediaries, provided that certain conditions are
met.
initial intention of the ban is interests. In these examples, the
134 A recent study on the effects of Regulation FD straightforward, over time its exemption could be lost (and all
finds that when smaller companies lost analyst application has become complex. Few purchasers could seek a return of their
coverage after the regulation was enacted their cost bright-line tests exist, and issuers are invested funds) even though none of the
of capital increased significantly. See Armando required to make highly subjective offerees contacted in an impermissible
Gomes et al., SEC Regulation Fair Disclosure,
Information, and the Cost of Capital (Rodney L. determinations concerning whether manner became purchasers. As a result,
White Center for Fin. Research, Wharton School U. their actions might be construed as prudence dictates that the available
Pa., Working Paper No. 10567) (July 8, 2004). impermissible. Among the factors the methods used to contact offerees be very
135 Rebecca Buckman, Tougher Venture: IPO
SEC staff has considered in determining limited. In our view, concerns with
Obstacles Hinder Start-ups, Wall St. J., Jan. 25, avoiding improper general solicitation
2006, at C1.
if a general solicitation has occurred are:
136 Section 17(b) of the Securities Act provides: the number of offerees; their suitability or advertising have the effect of focusing
‘‘It shall be unlawful for any person, by the use of as potential investors; how the offerees a disproportionate amount of time and
any means or instruments of transportation or were contacted; and whether the effort on persons who may never
communication in interstate commerce or by the offerees have a pre-existing business purchase securities—rather than on the
use of the mails, to publish, give publicity to, or actual investors and their need for
circulate any notice, circular, advertisement, relationship with the issuer.
newspaper, article, letter, investment service, or Beyond the difficulty of determining protection under the Securities Act.
Accordingly, we recommend the
communication which, though not purporting to if particular contact is impermissible,

offer a security for sale, describes such security for however, the current ban on general adoption of a new private offering
a consideration received or to be received, directly exemption that would permit sales
or indirectly, from an issuer, underwriter, or dealer, solicitation and advertising effectively
without fully disclosing the receipt, whether past or
made only to certain eligible purchasers
prospective, of such consideration and the amount 137 See, e.g., SEC Release No. 33–285 (Jan. 24, who do not require the full protections
thereof.’’ 1935). afforded by the securities registration
process under the Securities Act new exemption would be ‘‘covered and other mass media to engage in
because of (1) financial wherewithal, (2) securities’’ within the meaning of ‘‘pump and dump’’ or other
investment sophistication, (3) Section 18 of the Securities Act and manipulative schemes.
relationship to the issuer or (4) generally exempted from the securities The proposed exemption is not a
institutional status. An offering whose registration requirements of individual radical change in the fundamental
purchasers consisted solely of eligible state securities laws. This course of regulatory rationale regarding exempt
purchasers of these types would qualify action is crucial to the efficacy of the private offerings. In all the private
for the exemption regardless of the new exemption. offerings since the beginning of
means by which they were contacted— • The new exemption will need a regulatory time, no offeree has ever lost
even through advertising or general two-way integration or aggregation 143 any money unless he or she became a
solicitation activities, subject to the safe harbor similar to that included in purchaser. The new exemption reduces
restrictions noted below. SEC Rule 701.144 Under such a safe the issuer’s obligations regarding non-
• The class of eligible purchasers harbor, offers and sales made in investors and refocuses on the need (or
would be comprised of several compliance with the new exemption lack thereof) that actual purchasers
categories of natural persons and legal would not be subject to integration or have for the protections afforded by the
entities and would be defined in a aggregation with offers and sales made securities registration process.
manner similar to that used in under other exemptions or in registered We believe that this suggested change
Regulation D under the Securities offerings. Similarly, offers and sales can be viewed as a logical continuation
Act 138 to define the term ‘‘accredited made under other exemptions or in of an established regulatory trend to
investors.’’ 139 registered offerings would not be subject loosen the restrictions on what can be
• Natural persons would qualify as to integration or aggregation with done with non-purchasers consistent
eligible purchasers based on (1) wealth transactions under the new exemption. with investor protection. The SEC has
or annual income, (2) investment • As a means of guarding against relaxed restrictions on offers in other,
sophistication,140 (3) position with or potential abuse, we envision that all less bold ways.146 Almost a decade ago,
relationship to the issuer (officer, solicitations made by means of mass Linda Quinn, the long-time Director of
director, key employee, existing media (e.g., newspapers, magazines, the Division of Corporation Finance,
significant stockholder, etc.) or (4) pre- mass mailings or the Internet) would be proposed adopting an exemption
existing business relationship with the restricted in scope to basic information substantially similar to that being
issuer. Persons closely related to or about the issuer, similar to that found in recommended.147
associated with eligible purchasers Securities Act Rule 135c (currently a 146 Rule 254, 17 U.S.C. 230.254, which is
would also qualify as eligible permissive rather than restrictive available for use only in Regulation A exempt
purchasers. provision, and one applicable only to offerings, allows issuers before approval of the
• The financial wherewithal Exchange Act reporting companies).145 offering by the SEC to ‘‘test the waters’’ with
standards for natural persons to qualify Solicitations made in face-to-face activities that would otherwise be considered
improper advertising or general solicitation;
as eligible purchasers would be meetings would not be subject to these because of the extremely infrequent use of
substantially higher than those currently restrictions. Regulation A offerings and an incompatibility with
in effect for natural person Accredited The proposed exemption would not comparable state securities laws, ‘‘test the waters’’
Investors.141 We suggest $2 million in remove the SEC’s authority to regulate has been of little practical utility to the capital
formation process. In addition, the SEC staff has
joint net worth or $300,000 in annual offers of securities. All offering activities issued interpretive letters advising registered
income for natural persons and conducted under the new exemption broker-dealers that certain limited generic
$400,000 for joint annual income.142 would continue to be fully subject to the solicitation activities (including Internet-based
• Legal entities would qualify as antifraud provisions of the federal solicitation) would not amount to impermissible
advertising or general solicitation. See, e.g.,
eligible purchasers if they qualify as securities laws. Moreover, disclosure Interpretative Letters E.F. Hutton Co. (Dec. 3, 1985),
accredited investors under Regulation restrictions modeled after the current H.B. Shaine & Co, Inc. (May 1, 1987) and IPOnet
D. safe harbor found in Rule 135c would (July 26, 1996). But for these favorable
• The SEC should adopt the new ensure that issuers could not utilize the interpretations, the conduct described in the letters
might have been interpreted as impermissible
exemption amending Regulation D or Internet, television, radio, newspapers advertising and general solicitation. In this regard,
adopt an entirely new amendment the staff has not extended its interpretation to cover
under Section 4(2) of the Securities Act, 143 As the Commission is aware, ‘‘integration’’ conduct by issuers (or other non-broker-dealers)
so that securities sold in reliance on the refers to the SEC doctrine by which all offers and that would allow them to engage in the solicitation
sales separated by time or other factors are activities described in the broker-dealer
nevertheless treated as part of a single offering. interpretative letters.
138 17 CFR 230.501–508. Offers and sales believed to be part of separate 147 Expressing her views about securities reform
139 See Securities Act Rule 501(a) under offerings that are integrated into a single offering are when she was leaving the staff of the Division of
Regulation D, 17 CFR 230.501(a). required to either comply with a single exemption Corporation Finance, Ms. Quinn endorsed
140 Under Regulation D, investment sophistication from registration or be registered. Otherwise, they modifications in the Securities Act exemption
is the ability, acting alone or with the assistance of will violate Section 5 and trigger rescission rights regime consistent with the proposed exemption.
others, to understand the merits and risks of making for all purchasers. The SEC integration doctrine See L. Quinn, Reforming the Securities Act of 1933:
a particular investment. underpins much of the existing Securities Act A Conceptual Framework, 10 Insights 1, 25 (Jan.
141 Under Regulation D as currently in effect, registration exemption framework; without it, 1996). Ms. Quinn supported the use of ‘‘public
natural person accredited investors must have a net evading the Securities Act’s registration offers’’ in exempt private offerings whose
worth of $1 million (including property held jointly requirements would be possible by artificially purchasers were limited to ‘‘qualified buyers’’:
with spouse) or $200,000 in individual or $300,000 separating an otherwise non-exempt offering into In sum, offers would not be a Section 5 event and
joint annual income. Rule 501(a)(6). two more distinct transactions and claiming an therefore would not be a source of Section 12(1)
142 There was support in the subcommittee for exemption for each transaction. liability. * * * Offering communications would
144 17 CFR 230.701.
recommending the use of the financial wherewithal and should still be subject to the antifraud laws.
standards for natural person Accredited Investor in 145 17 CFR 230.135c. A somewhat similar * * * This approach could be effected by the
Regulation D for the eligible purchaser standards. structure has been established by the North Commission defining these communications as
It was our impression from informal discussions American Securities Administrators Association outside the scope of offers for purposes of Section
with federal and state regulatory officials that an and adopted in 23 states. See, e.g., Texas 5 of the Securities Act, subject to conditions
increase in the financial wherewithal standards for Administrative Code Rule 139.19, which sets forth deemed appropriate. The test-the-waters proposal
natural persons was the sine qua non for obtaining the information that can be included in the makes such use of the Commission’s definitional
regulatory support for this proposal. announcement. authority. * * * Id. at 27.
As a corollary to our recommendation solicitations in this manner, we believe services provided in support of capital
concerning a lifting of the ban on that much benefit, and very little harm, formation and M&A activities amount to
general solicitation when sales are made would result from a relaxation of the unregistered broker-dealer activities that
to certain eligible purchasers who do current advertising/solicitation ban of violate federal and state broker-dealer
not need the full protection of Securities Rule 502(c). registration and regulation law. For the
Act registration, we further recommend As with the recommendation most part, the services provided do not
that the Commission relax prohibitions immediately above, in order to work involve holding customers’ funds,
against general solicitation and effectively the new exemption will need which is a traditional function of many
advertising found in Rule 502(c) under to be implemented by adoption of a new registered broker-dealers. These
the Securities Act to parallel the ‘‘test or amended rule under Section 4(2) of unregulated service providers have a
the waters’’ model of Rule 254 under the Securities Act, such that securities great reluctance to register as broker-
that Act. Whereas the former would sold in reliance on the new exemption dealers under the current regulatory
generally maintain investor protection would be ‘‘covered securities’’ within framework. The enforcement activity
by limiting sales of securities to persons the meaning of Section 18 of the against them seems minimal. The cost
that time and experience have Securities Act and consequently and administrative burdens of the
demonstrated do not need protections exempted from state securities current regulatory scheme are daunting
afforded by full registration, this registration requirements. to both the money finding and M&A
recommendation would do so by Recommendation IV.P.6 communities. The absence of a workable
limiting the information included in a registration scheme means that issuers
general solicitation similar to that Spearhead a multi-agency effort to cannot currently use broker-dealer
allowed in a Regulation A ‘‘test the create a streamlined NASD registration registration as an element in
waters’’ solicitation.148 Both measures process for finders, M&A advisors and differentiating between such providers.
would, in our view, significantly ease institutional private placement
The proposal seeks to foster a scheme of
the difficulties that smaller companies, practitioners.
registration and regulation, substantially
the largest users of private offering As detailed in a recent report
in accordance with the ABA Task Force
exemptions, encounter in locating published in the Business Lawyer,151
Proposal outlined in the Business
suitable investors. there exists an unregulated underground
Lawyer article referenced above, that
Although we defer to the Commission ‘‘money finding’’ community that
will be cost-effective for the
as to the exact parameters of permissible services companies unable to attract the
unregistered community and support
solicitation, we anticipate that any attention of registered broker-dealers,
the investor protection goals of
soliciting materials would be subject to venture capitalists or traditional angel
securities regulation.
restrictions modeled on those found in investors.152 Many smaller companies
rely on this community to assist them in An unregistered money finder will
current Rule 254.149 Issuers would be never ‘‘come in from the cold’’ to
required to include disclosure to the raising capital. A separate community of
unregistered and therefore unregulated register if the regulators reserve the right
effect that no money or other to institute enforcement actions based
consideration is being solicited, that an M&A consultants who assist buyers and
sellers with services and receive solely on past failure to register.
indication of interest by a prospective Accordingly, a workable amnesty
investor involves no obligation or compensation substantially similar to
those provided and earned by program is also crucial to the success of
commitment of any kind, and that no the proposal. Regulatory amnesty
sales of securities will be made until traditional registered investment
bankers also exists. Virtually all of the should not extend to fraud nor be a
after the suitability of a potential defense against private causes of action.
investor for purposes of the applicable
in fact, do not sell to their residents, you have not The private placement broker-dealer
Regulation D exemption has been
made an illegal offering in that state. The proposal is not new. It has been ‘‘on the
determined. Companies would also be Commission has used the same approach for table’’ for a number of years, and
required to include contact information, offerings posted by foreign companies on their web
indeed, has been a top recommendation
in order to communicate with those sites. As long as foreign companies indicate they are
not offering securities to U.S. citizens, their Internet of the annual SEC Government-Business
expressing interest and thereafter
posting is not an offering in the United States Forum on Small Business Capital
establish whether they fit within the subject to the registration requirements of the Formation for nine of the past ten years.
suitability/accreditation standards for federal securities laws. Why then prohibit a private
This demonstrates that other
the offering before making a formal offer placement as long as (1) it includes a warning that
it will not sell to investors who do not meet the individuals and groups agree with our
of securities, and a disclaimer to the
definition of an accredited investor and (2) does view that this proposal is important to
effect that the offering itself may only be not, in fact, sell to unsophisticated investors? Who improve small business capital
made to investors that satisfy the is harmed?’’ Speech by Brian J. Lane to the
formation. To date, however, none of
standards of the Securities Act American Bar Association (Nov. 13, 1999),
available at http://www.sec.gov/news/speech/ the affected regulatory bodies have
exemption upon which the company
speecharchive/1999/spch339.htm. taken action. We believe the SEC must
intends to rely.150 By restricting 151 Task Force on Private Placement Broker-
provide leadership if this proposal is to
Dealers, ABA Section of Business Law, Report and succeed. That leadership must come
148 17 CFR 230.254. Recommendations of the Task Force on Private
149 Rule 254 was adopted in 1992 and has not Placement Broker-Dealers, 60 Bus. Lawyer 959– first from the Commission itself, and
been updated. We recommend that the SEC staff 1028 (May 2005), available at http:// then the agency must reach out to the
review the provisions of Rule 254 and harmonize www.abanet.org/buslaw/tbl/tblonline/2005_060_03/ NASD and the state regulators.
the recommended changes to take into account the home.shtml#1. We note that the Texas State
changes in SEC policy and practice since 1992, Securities Board is also drafting a finder proposal. Corporate Governance, Disclosure and
including the SEC’s recently adopted securities 152 Section 15(a)(1) of the Exchange Act defines
Capital Formation—Secondary
offering reforms. broker-dealers as persons who ‘‘effect any

150 As noted by a former Director of the SEC
Recommendations
transaction in, or * * * induce or attempt to induce
Division of Corporation Finance, the use of such the purchase or sale of, any security’’ and makes it In addition to the foregoing primary
disclaimers is an accepted practice under existing unlawful to carry on broker-dealer activities in the
securities laws: ‘‘Almost all 50 states recognize that absence of SEC registration or exemption. Most
recommendations in the area of capital
if you advertise on the Internet but disclaim that state securities laws include similarly broad general formation, corporate governance and
you are not selling securities to their residents, and, definitions and prohibitions. disclosure, we also submit for the
Commission’s consideration the today, because shares held in street or rulemaking petition.162 We received
following secondary recommendations: nominee name are listed in the stock other letters in support of rulemaking in
ledger as held in the names of brokers, this area.163
Recommendation IV.S.1
dealers, banks and nominees. This The trend of going dark is an area of
Amend SEC Rule 12g5–1 to interpret interpretation originally was adopted to concern to us. An issuer ‘‘goes dark’’
‘‘held of record’’ in Exchange Act simplify the process of determining when holders of record of all classes of
Sections 12(g) and 15(d) to mean held whether an issuer is required to report securities fall below the 300 holder
by actual beneficial holders.153 under Section 12(g). threshold and it files a Form 15
In order for our recommendation that terminating its reporting obligations
As noted above, Congress added
the Commission establish a new system under Section 12(g) or suspends its
Section 12(g) to the Exchange Act in
of scaled or proportional securities obligations under Section 15(d).164 This
1964 to extend the reach of most of the
regulation for smaller public companies procedure of going dark is contrasted
Exchange Act’s public company
to apply uniformly and to adequately with the going private procedures
reporting and disclosure provisions to
protect investors, the rules under which pursuant to Rule 13e–3.165 Companies
equity securities traded over-the
companies are required to enter and that go private typically buy back
counter. That provision requires all
allowed to exit the underlying securities from shareholders through an
disclosure system must not be subject to companies with a class of equity
offering document using Rule 13e–3,
manipulation and circumvention. By securities held of record by at least 500
which is filed with the Commission.
law, companies must enter the system persons to register with the
When the Commission first adopted
under Section 12(b) of the Exchange Act Commission.158 Companies registered
Rule 12g5–1 in 1965, approximately
when they register a class of securities with the Commission are required to file
23.7% of securities were held in
on a national securities exchange, under annual and quarterly reports with the
nominee or street name.166 In late 2002,
Section 12(g) of the Exchange Act when SEC and to comply with the other rules
it was estimated that over 84% of
they have 500 equity shareholders of and regulations applicable to public
securities were held in nominee or
record and $10 million in assets, and companies.159
street name.167 The Nelson Law Firm
under Section 15(d) of the Exchange Act Exchange Act Rules 12g–4 and 12h– and other proponents of such an
when they have filed a registration 3 160 regulate when an issuer can exit amendment to Rule 12g5–1 believe that
statement under the Securities Act that the reporting system under Section 12(g) the current definition of ‘‘held of
becomes effective.154 Companies may be or Section 15(d). These rules allow an record’’ allows a company to
entitled to exit the system when their issuer to terminate its Exchange Act
securities are removed from listing on a reporting with respect to a class of 162 Letter from Nelson Obus to Committee (Apr.
national securities exchange and when securities held of record by fewer than 7, 2005), available at http://www.sec.gov/rules/
other/265–23/26523–1.pdf.
they have fewer than 300, or sometimes 300 persons, or fewer than 500 persons 163 Letter from James Brodie to Committee (Apr.
fewer than 500, equity shareholders of where the total assets of the issuer have 12, 2005), available at http://www.sec.gov/rules/
record.155 The rules for entering and not exceeded $10 million on the last day other/265–23/jabrodie9204.htm; Letter from
exiting the Exchange Act reporting of the three most recent fiscal years. Stephen Nelson to Committee (June 8, 2005),
system have come into increasingly available at http://www.sec.gov/rules/other/265–23/
The Nelson Law Firm, on behalf of a sjnelson060805.pdf.
sharp focus in recent years, due in part group of institutional investors, recently 164 See Christian Leuz et al., Why do Firms go
to the increasing costs associated with filed a rulemaking petition with the SEC Dark? Causes and Economic Consequences of
complying with the reporting and other requesting the Commission to take Voluntary SEC Deregistrations, Wharton Fin’l Inst.
obligations of reporting companies Center Paper No. 04–19 (Nov. 2004), available at
immediate action to amend Rule 12g5– http://fic.wharton.upenn.edu/fic/papers/04/
under the Exchange Act. 1 to count all accounts as holders of 0419.pdf; see also Andras Marosi & Nadia Massoud,
We have concluded that, because of record.161 This petition highlighted the Why Do Firms Go Dark? (3d ver. Nov. 2004),
the way that SEC rules permit the available at http://www.umanitoba.ca/faculties/
practice by some issuers of using street management/cgafinance/Massoud.pdf#
counting of equity shareholders ‘‘of
or nominee holders as a technique to search=’Andras%20Marosi%20Why%20
record’’ under Exchange Act Rule 12g5–
reduce the number of record holders firms%20go%20dark%3F.
1,156 circumvention and manipulation 165 17 CFR 240.13e–3. For a detailed explanation
below 300 and exit the Exchange Act
of the entry and exit rules for the SEC’s of going private transactions, see Marc Morgenstern
reporting system. The petition cited
public company disclosure system is & Peter Nealis, Going Private: A Reasoned Response
numerous companies that had fewer to Sarbanes-Oxley?, (2004), available at http://
possible and occurs. Rule 12g5–1,
than 300 record holders as determined www.sec.gov/info/smallbus/pnealis.pdf.
which was adopted by the Commission
in accordance with Rule 12g5–1, but 166 Final Report of the Securities and Exchange
in 1965, interprets the term ‘‘security Commission on the Practice of Recording the
thousands of beneficial owners and total
held of record’’ in Section 12(g) for U.S. Ownership of Securities in the Records of the Issuer
assets of approximately $100 million or in Other than the Name of the Beneficial Owner of
companies to include only securities
more. We also received a letter Such Securities Pursuant to Section 12(m) of the
held by persons identified as holders in
discussing and supporting the Securities Exchange Act of 1934, at 53–55 (Dec. 3,
the issuing company’s stock ledger.157 1976) (the ‘‘Street Name Study’’).
This excludes securities held in street or 158 15 U.S.C. 781(g). Section 12(g) does not
167 As of June 23, 2004, the DTCC estimated that
nominee name, which is very common require registration if the company does not have
approximately 85% of the equity securities listed
on the NYSE, and better than 80% of equity
a minimal level of assets. The level was $1 million securities listed on the NASDAQ and AMEX, are
153 Although overall this recommendation passed
in the original statute, but the Commission had immobilized. See Letter from Jill M. Considine,
unanimously, Messrs. Schacht and Dennis raised the threshold to $10 million by rule by 1996. Chairman and CEO of DTCC, commenting on
dissented from the majority vote with respect to See Relief from Reporting by Small Issuers, SEC Securities Transaction Settlements, SEC Release No.
that portion of the recommendation specifying that Release No. 34–37157 (May 1, 1996) [61 FR 21354]. 33–8398 (Mar. 18, 2004) [69 FR 12922] (on file in
holders of unexercised stock options issued in
159 Section 13(a) of the Exchange Act requires

SEC Public Reference Room File No. S7–13–04,
compliance with Rule 701 not be included as companies registered with the Commission to file available at http://www.sec.gov/rules/concept/
holders for purposes of Rule 12g5–1. annual and quarterly reports with the SEC.
154 15 U.S.C. 78l(b), 78l(g) & 78o(d).
s71304/s71304–26.pdf. The DTCC immobilization
160 17 CFR 240.12g–4 and 240.12h–3.
program is aimed at eliminating physical securities
155 17 CFR 240.12h–3 & 17 CFR 240.12g–4. 161 See Rulemaking Petition of Nelson Law Firm certificates and its ultimate objective is to place all
156 17 CFR 240.12g5–1.
to SEC (July 3, 2003), available at http:// equity securities ownership in a direct registration
157 17 CFR 240.12g5–1. www.sec.gov/rules/petitions/petn4–483.htm. system which is a street name system.
manipulate its number of record holders stock options should not be a factor in rather than on brokers and market-
to circumvent the intent of Section 12(g) determining the point an issuer becomes makers.
of the Exchange Act. subject to the burdens of a reporting
The substantial increase in securities company under the Exchange Act. Recommendation IV.S.3
held by nominees or in street name has Form a task force, consisting of
led to the circumvention of the Recommendation IV.S.2
Make public information filed under officials from the SEC and appropriate
intention of Section 12(g) by enabling
Rule 15c2–11. federal bank regulatory agencies to
issuers with a significant number of
A major problem with the market for discuss ways to reduce inefficiencies
shareholders to avoid registration, or
deregister, if their equity holders are over-the-counter securities, where many associated with SEC and other
aggregated into a smaller number of issuers are not required to file reports governmental filings, including
nominee or record holders. with the SEC, is the lack of reliable, synchronizing filing requirements
In light of the above considerations, publicly available information on involving substantially similar
we recommend that the Commission issuers.169 In theory, Exchange Act Rule information, such as financial
amend Rule 12g5–1 or its interpretation 15c2–11, which prohibits brokers from statements, and studying the feasibility
so that all beneficial owners are counted publishing quotations on an OTC of extending incorporation by reference
for purposes of calculating the number security unless they have obtained and privileges to other governmental filings
of shareholders for purposes of Section reviewed current information about the containing substantially equivalent
12(g) of the Exchange Act and the rules issuer, could operate as a modest information.
thereunder. We recommend that the disclosure system under which We received a number of comment
Commission request its Office of investors could access basic issuer letters from banks and banking trade
Economic Analysis or some other information if the company is not associations expressing concern about
professional organization conduct a required to become a reporting company what they consider duplicative filing
study to determine the effects on the under Section 12(g) or 15(d). In practical requirements of the SEC and other
number of companies required to terms, however, access to 15c2–11 governmental agencies and the costs
register if this recommendation is information is extremely limited. and efficiencies that have resulted.171
adopted. The study should also consider Broker-dealers are required to file 15c2– Additionally, banks have advised us
whether a standard other than number 11 information with the NASD only,170
that they are subject to duplicative
of shareholders would be a better to retain such information in their files
internal control requirements of various
determinant of when a company should and to provide such information, upon
governmental regulators. We believe
be required to enter or allowed to exit request, to individual investors. Broker-
this recommendation is extremely
the SEC disclosure system. After the dealers are not required to publish this
information in a widely available important. Although we leave it to the
study is completed, the Commission or
location or provide it to investors on an Commission’s discretion as to how best
Congress can decide whether the intent
ongoing and systematic basis. The result to implement this recommendation, we
of Section 12(g) would be better served
is an over-the-counter market in which further believe that the introduction of
by changing the number of shareholders
the securities of literally thousands of XBRL may make this recommendation a
that triggers Exchange Act reporting
from 500 to some other number. We issuers are traded, but about which more attractive option in today’s world.
believe that such a study is important current public information is uneven We wish to state that in making this
because of the possibility of and in some cases non-existent. In our recommendation, we are in no way
circumvention and manipulation of the view, these conditions create the advocating an expansion of disclosure
SEC’s rules for entering and exiting the potential for fraud and manipulative of personal bank information beyond
disclosure system. The significant abuse. what is currently permitted.
increase of costs associated with In order to address this problem, we
compliance with the registration and recommend that the Commission take 171 See Record of Proceeding 48 (June 17, 2005)
action to provide for public availability (testimony of William A. Loving, Chairman and
ongoing reporting obligations of the CEO of Pendleton County Bank representing the
Exchange Act make this issue urgent. of Rule 15c2–11 information. Although Independent Community Bankers of America);
We also received testimony 168 we defer to the Commission on the exact Letter from Independent Community Bankers of
suggesting that employee stock options means by which this information would America to Committee (Mar. 31, 2005), available at
(those issued in compensatory be made available, we feel that an http://www.sec.gov/info/smallbus/acspc/icba.pdf;
Letter from Christopher Cole of Independent
transactions) not be considered a class orderly and reliable disclosure system Community Bankers of America to Committee (Apr.
of equity securities for purposes of adopted under the SEC’s antifraud 8, 2005), available at http://www.sec.gov/rules/
triggering the registration requirements authority could place the burden of other/265-23/ccole040805.pdf; Letter from Kathryn
under Section 12(g) of the Exchange disclosure on issuers, by requiring that Burns, Vice President and Director of Finance,
Monroe Bank to Committee (May 24, 2005),
Act. We support this view. As they post a minimal level of available at http://www.sec.gov/rules/other/265-23/
exemplified by the policy underlying documentation on their company web kburns052405.pdf; Letter from Charlotte Bahin,
the Rule 701 exemption under the site, and on the NASD, by requiring that Senior Vice President, America’s Community
Securities Act, we believe that holders it create and maintain an information Bankers to Committee (July 19, 2005), available at
http://www.sec.gov/rules/other/265-23/
of employee stock options received in repository of Form 211s it has received, acbankers071905.pdf; Letter from Mark A.
compensatory transactions are less Schroeder, President and CEO, German American
likely to require the full protections 169 For statistics concerning over-the-counter
Bankcorp to Committee (August 3, 2005), available
afforded under the registration issuers not required to file reports with the SEC, see at http://www.sec.gov/rules/other/265-23/
Appendices I and J. maschroeder080305.pdf; Letter from Charlotte
requirements of the federal securities 170 See NASD Rule 6740 (Submission of Rule Bahin, Senior Vice President, America’s
laws. Therefore, we believe that such
15c2–11 Information on Non-NASDAQ Securities). Community Bankers, to Committee (Aug. 9, 2005),

To demonstrate compliance with both NASD Rule available at http://www.sec.gov/rules/other/265-23/
168 Record of Proceedings 64 (Sept. 19, 2005) 6740 and SEC Rule 15c2–11, a member must file cmbahin080905.pdf; Letter from David
(testimony of Ann Walker, Esq. before the joint with NASD a Form 211, together with the Bochnowski, President and CEO of Northwest
meeting of the Committee and the Small Business information required under SEC Rule 15c2–11(a), at Indiana Bancorp to Committee (Aug. 9, 2005),
Forum), available at http://www.sec.gov/rules/ least three business days before the quotation is available at http://www.sec.gov/rules/other/265-23/
other/265–23/jh-sk-ajm-ayw-gcy091205.pdf. published or displayed. dbochnowski080905.pdf.
Recommendation IV.S.4 workplaces and most homes and public the fairness of the transaction. The going
Allow companies to compensate libraries. The EDGAR system has not private process generally includes the
market-makers for work performed in been updated to reflect these advances. participation of investment banking
connection with the filing of a Form Many companies, but especially firms, law firms and accountants, and
211, with full disclosure of such smaller public companies, find the hence results in substantial transaction
compensation arrangements. EDGAR system unnecessarily complex costs.
The filing of a Form 211, and and costly, and usually must engage While the significance of the
compliance with the diligence and costly third party vendors to file their transaction and the possibility for
NASD review and comment process that reports with the Commission. We conflicts of interest and insider abuse in
such a filing entails, generally requires believe that the system’s complexity and a true ‘‘going private’’ transaction (i.e.,
that a market-maker expend substantial cost serves as an unnecessary burden on one in which a controlling group
time, effort and funds. Current NASD capital formation for smaller public undertakes a corporate transaction in
rules, however, prohibit market-makers companies. order to acquire the entire equity
from recouping any compensation or In this regard, we encourage the interest in a corporation) justify this
reimbursement for their outlay.172 Commission to pursue the use of heightened scrutiny, the Committee
While acknowledging the need for Internet standards (e.g., eXtensible believes that microcap companies that
restrictions on payments by issuers to Business Reporting Language, or XBRL) wish to go dark should be entitled to a
market-makers, we believe that in the and protocols (e.g., web services) in the simplified SEC review process
limited context of the Form 211 filing announced EDGAR modernization conditioned on the issuer undertaking
process, NASD rules act to discourage project as a method to reduce costs to provide the remaining shareholders
market-making activity and impede the associated with the preparation of with periodic financial and other
creation of a fair and orderly trading registrant filings and the subsequent pertinent information, such as
market in securities of over-the-counter access and use of filed information by unaudited quarterly financial
companies, most of which are smaller the Commission’s staff and the financial statements, annual GAAP audited
public companies. If Rule 15c2–11 is to community. We believe that the use of financial statements and narrative
remain focused on broker-dealer rather highly interoperable business reporting information about basic corporate
than issuer disclosure (see our formats will lower information access governance, executive compensation
recommendation immediately above) costs by the analyst and investor and related party transactions as long as
then we recommend that the community and thereby enhance the their shares trade in a public market.
Commission encourage the NASD to analysis and liquidity of the securities This approach would ensure that
modify its rules to allow issuers to of smaller public companies. investors in such companies receive
compensate market-makers for work information necessary for operations
Recommendation IV.S.6 transparency and protection of their
they perform in connection with the
filing of a Form 211 (including diligence Make it easier for microcap interests.
costs and costs associated with the companies to exit the Exchange Act Recommendation IV.S.7
NASD review process), if the reporting system.
As noted elsewhere in this report,174 Increase the disclosure threshold of
compensation arrangement is fully
we have found that the costs associated Securities Act Rule 701(e) from $5
disclosed. We believe this approach will
with implementing the requirements of million to $20 million.
encourage dealers to engage in market- The SEC adopted Rule 701 in April
making and foster a more efficient and the Sarbanes-Oxley Act are borne
disproportionately by smaller public 1988 to provide an exemption from the
viable market for over-the-counter registration requirements under the
securities issuers. companies. For a significant percentage
of companies—particularly those at the Securities Act for offers and sales of
Recommendation IV.S.5 lower end of the market capitalization securities by non-reporting companies
Evaluate upgrades or technological spectrum, many of which went public to their employees. The Commission
alternatives to the EDGAR system so in the pre-Sarbanes-Oxley era—these amended Rule 701 in 1999 to, among
that smaller public companies can make disproportionate costs are compounded other things, replace the fixed aggregate
their required SEC filings without the because they enjoy none of the $5 million offering ceiling contained in
need for third party intervention and traditional benefits of being public: their the original rule with a more flexible
associated costs. stock receives little or no analyst limit that required, among other items,
Since the SEC’s EDGAR system 173 coverage, has a limited trading market, disclosure of financial statement and
was inaugurated in 1993, significant provides limited liquidity for their risk factor information if the aggregate
technological advances have occurred, shareholders, and attracts little amount of securities sold under Rule
including pervasive market deployment institutional investment. They also 701 exceeded $5 million in any 12-
of Internet standards and protocols, experience a diminished ability to gain month period.
software interoperability and embedded Over time, Rule 701 has proved to be
access to investment capital in the
features. Computers with Internet an extraordinarily useful exemption for
public markets, particularly during a
capability are available in almost all both small businesses and large private
market downturn. For such companies,
companies, and for the most part
the burdens of public company status
172 NASD Rule 2460 (Payments for Market continues to work well. Nonetheless,
may far outweigh the benefits.
Making) provides: ‘‘No member or person the disclosure of financial statement
associated with a member shall accept any payment At the same time, current SEC
information has been problematic for
or other consideration, directly or indirectly, from regulations require companies that wish
growing companies in recent years as a
an issuer of a security, or any affiliate or promoter to go private to submit to a lengthy SEC
result of the recent trend towards longer
thereof, for publishing a quotation, acting as review process, in which a company

market-maker in a security, or submitting an IPO incubation periods, particularly in
application in connection therewith.’’ must provide detailed disclosure as to
173 EDGAR is an abbreviation for the SEC’s
a ‘‘down’’ market environment, as well
Electronic Data Gathering, Analysis, and Retrieval 174 See discussion under the caption ‘‘Part II. as the increased use of equity awards as
System, which must be used by reporting Scaling Securities Regulation for Smaller an incentive for attracting/retaining
companies to file their reports with the SEC. Companies.’’ employees. For private companies that
hope to maintain the confidentiality of increasing steadily among all age Recommendation IV.S.9
their financial information for groups.177 Shorten the integration safe harbor
competitive reasons, the increasing need The SEC recently has taken several from six months to 30 days.181
for equity compensation presents a steps to facilitate electronic delivery of The concept of integration, discussed
dilemma: Disclose such information, filed documents filed with the Agency. above,182 has been the subject of intense
and expose yourself to potential criticism, almost since its inception,183
In connection with the recent Securities
competitive harm (particularly relative and small business issuers and their
Offering Reform effort, the Commission
to other private companies that are not legal advisors have long expressed
required to disclose such information), adopted Securities Act Rule 172
implementing an ‘‘access equals concerns about the absence of clarity in
or restrict equity awards to a limit below being able to determine the
that which business conditions and delivery’’ model in the context of final
prospectus delivery. The Commission circumstances under which integration
sound judgment might otherwise does (or does not) apply. Though the
dictate. has also recently proposed a rule
facilitating the electronic delivery of SEC attempted to introduce more
Based on the foregoing, we believe certainty into the determination by
proxy materials.178 In that release, the
that an increase in the disclosure introduction of a five-factor test in
Commission stated that its members
threshold of Rule 701(e) to $20 million 1961,184 as a practical matter the
represents a more appropriate balance ‘‘believe that continuing technological question of integration remains for
between the informational needs of developments and the expanded use of smaller companies an area fraught with
employee-investors and the the Internet now merit consideration of uncertainty—and therefore risk.185
confidentiality needs of private alternative methods for the Because of the link between
company issuers. The $5 million dissemination of proxy materials.’’ 179 In integration and the availability of
threshold was actually established in the access equals delivery model Regulation D and other registration
1988, based upon the Commission’s investors would be assumed to have exemptions, and consequently the
small issue exemptive limit at the access to the Internet thereby allowing ability of a smaller company to
time.175 The Committee’s proposed delivery to be accomplished solely by undertake a private financing, we
increase would account for the amount an issuer posting a document on the believe that the SEC should provide
of the original threshold that has been issuer’s or third party’s Web site. This smaller companies with clearer
diminished due to inflation (as a point presumption differs from the current guidance concerning the circumstances
of reference, $5 million in 1988 would consent model where an investor must under which two or more apparently
equal approximately $8.35 million affirmatively consent to receiving separate offerings will or will not be
today) as well as provide issuers with documents electronically. integrated. After considering the
increased flexibility for granting equity difficulties of modifying the five-factor
We strongly support the proposed
awards without compromising test in order to encompass the entire
amendments to the proxy delivery rules.
confidentiality. range of potential offering scenarios, we
We believe these changes will reduce
In the event that the Commission concluded that shortcomings of the
the printing and mailing costs existing framework can most easily be
finds such increase in the disclosure associated with furnishing proxy
threshold to be inadvisable, we addressed by shortening the six-month
materials to shareholders, while not safe harbor of Regulation D and
recommend as an alternative that the impairing investor protection, as
financial statement disclosure applying the shortened safe harbor
shareholders desiring paper versions of across the entire universe of private
requirements be eliminated or modified such documents are able to obtain them
significantly if (1) options are non- offering exemptions.
at no cost under the proposal. We The Regulation D safe harbor provides
transferable except by law and (2) believe, however, that the Commission
options may only be exercised on a generally that offers and sales made
should go further and recommend that more than six months before the start of
‘‘net’’ basis with no employee funds
the Commission extend the access
paid to the issuer/employer.
equals delivery model for delivery to all 181 Although the Committee is recommending a
Recommendation IV.S.8 SEC filings, thereby providing the 30-day period, we are flexible in this regard.
182 See text accompanying note 208.
efficiencies and cost savings of
Extend the ‘‘access equals delivery’’ electronic delivery to all documents
183 See Stanley Keller, Basic Securities Act
model to a broader range of SEC filings. Concepts Revisited, Insights (May 1995).
required to be delivered under the 184 See, e.g., Perry E. Wallace, Jr., Integration of
Since 1995, the Commission has federal securities laws. The only Securities Offerings: Obstacles to Capital Formation
published guidance regarding the exception to our recommendation is Remain for Small Business, 45 Wash. & Lee L. Rev.
electronic delivery of materials under 935, 937, 972–975 (1988) (integration doctrine
delivery of preliminary prospectuses in ‘‘frustrates issuers engaged in the capital formation
the federal securities laws.176 Recent initial public offerings in Rule 15c2– process, engulfing them in a sea of ambiguity,
studies indicate that 75% of Americans 8.180 uncertainty and potential liability’’ and ‘‘of the
have access to the Internet in their various sources of angst facing the small issuer,
homes, and that this percentage is none has proved more frustrating and elusive than
177 See Internet Availability of Proxy Materials,
the doctrine of integration of securities offerings’’).
SEC Release No. 34–52926 (Dec. 8, 2005) [70 FR Faced with these difficulties, academics and
175 Rule 701 was originally adopted under 74597], citing Three Out of Four Americans Have practitioners have long argued for change to the
Securities Act Section 3(b), which has a $5 million Access to the Internet, Nielson/NetRatings (Mar. 18, existing system, with some even arguing that the
limit, but was re-adopted in 1999 under Securities 2004). very concept of integration should be abolished. In
178 Id.
Act Section 28, which was no such limit. See Rule our view, however, this goes too far, as issuers
701—Exempt Offerings Pursuant to Compensatory 179 See Acceleration of Periodic Report Filing could then split their offerings among several
Arrangements (Mar. 8, 1999) [64 FR 11095]. Dates and Disclosure Concerning Website Access to different exemptions, thus vitiating the registration
176 Use of Electronic Media for Delivery Purpose; Reports, SEC Release No. 34–46464 (Apr. 8, 2003) process upon which the Securities Act is premised.
Action: Interpretation; Solicitation of Comment, [67 FR 58480]; Acceleration of Periodic Report 185 The confusion over making an integration
SEC Release No. 33–7233 (Oct. 6, 1995) [60 FR Filing Dates and Disclosure Concerning Website determination is made more difficult because the
53458], provided the initial guidance on electronic Access to Reports; Correction, SEC Release No. 34– SEC staff does not currently render advice or
delivery of prospectuses, annual reports, and proxy 46464A (Sept. 5, 2003) [67 FR 17880]. provide no-action relief concerning integration
materials under the Securities and Exchange Acts. 180 17 CFR 240.15c2–8. questions.
a Regulation D offering or more than six officers.188 The prohibition was enacted unnecessary.’’ Section 18 also provides
months after completion of a Regulation following abuses associated with that sales to ‘‘qualified purchasers’’ are
D offering will not be considered part of company loans in several well- by definition ‘‘covered securities.’’ The
that Regulation D offering.186 The safe publicized corporate scandals. To date, effect of defining ‘‘qualified
harbor is particularly significant for the SEC’s Division of Corporation purchasers,’’ therefore, would be to
smaller companies, who rely heavily on Finance has not provided interpretive exempt offers and sales to persons
Regulation D exemptions. Although it guidance with respect to Section 13(k). included in the definition from
provides certainty, however, the safe We believe that confusion exists among unnecessary state registration
harbor does so at the expense of public companies and their attorneys requirements.
flexibility, as it requires that as much as concerning the applicability of the loan The Commission in 2001 issued a
a full year elapse between offerings. For prohibition to a number of transactions release in which it proposed to define
smaller companies, whose financing that could be construed as loans. ‘‘qualified purchaser’’ to have the same
needs are often erratic and We strongly support the loan meaning as the term ‘‘accredited
unpredictable, the duration of the safe prohibition contained in Section 13(k) investor’’ under Rule 501(a) of
harbor period is often problematic; even of the Exchange Act. We recommend Regulation D.190 Although the
a well meaning issuer that needs access that the SEC staff seek to provide Commission solicited comment from
to capital, because of changed clarifying guidance as to the types of interested parties, it took no further
circumstances or greater than transactions that fall outside the action on the proposal, in part because
anticipated need for funding, may be prohibition. of the opposition of state securities
unable to access such funds without In particular, we recommend that the regulators.191
running afoul of Section 5. SEC’s Division of Corporation Finance The Committee applauds the SEC’s
Inasmuch as the alternative to the safe clarify whether Section 13(k) prohibits initiative in issuing the qualified
harbor is the inherent uncertainty of the the cashless exercise of stock options, purchaser release, and recommends that
five-factor test, the practical effect of the indemnity advances, relocation the ideas expressed in the release,
waiting period between Regulation D accommodations to new hires and split principally, that all ‘‘accredited
offerings is to undermine issuers’ dollar life insurance polices. We believe investors’’ be deemed ‘‘qualified
flexibility and impede them from that these transactions, if approved by purchasers,’’ be adopted substantially as
obtaining financing at a time that independent directors, are unlikely to proposed. The release states, and we
business goals, and good judgment, lead to the abuses envisioned under agree, that defining ‘‘qualified
would otherwise dictate. Section 402 of the Sarbanes-Oxley Act. purchaser’’ to mean ‘‘accredited
In short, we believe that the dual six- Recommendation IV.S.11 investor’’ would strike the appropriate
month safe harbor period represents an balance between the need for investor
unnecessary restriction on companies Increase uniformity and cooperation protection and meaningful regulatory
that may very well be subject to between federal and state regulatory relief from duplicative state regulation
changing financial circumstances, and systems by defining the term ‘‘qualified for issuers offering securities, in
weighs too heavily in favor of investor investor’’ in the Securities Act and particular small businesses.192 Investor
protection, at the expense of facilitating making the NASDAQ Capital Market protection would be maintained, as
capital formation. We believe that a and OTCBB stocks ‘‘covered securities’’ accredited investors have long been
shorter safe harbor period between under NSMIA. deemed not to require the full
In fulfillment of our basic mandate— protection of Securities Act registration
offerings of 30 days strikes a more
to identify methods of minimizing costs and have sufficient bargaining power to
appropriate balance between the
and maximizing benefits—we believe it gain access to information with which
financing needs of smaller companies
is important to increase uniformity and to make informed investment decisions.
and investor protection, while
cooperation between federal and state As the Commission is aware, in 1996
preserving both investor protection and
securities regulatory systems by NSMIA realigned the relationship
the integrity of the existing registration/
eliminating unnecessary and between federal and state regulation of
exemption framework.
duplicative regulations. the nation’s securities markets in order
Recommendation IV.S.10 In our view, this can be accomplished to eliminate duplicative costs and
by both (1) defining ‘‘qualified improve market efficiency, while
Clarify the Sarbanes-Oxley Act
purchaser’’ as permitted by the National maintaining necessary investor
Section 402 loan prohibition.
Securities Markets Improvement Act of protections. Although NSMIA greatly
Section 402, of the Sarbanes-Oxley
1996,189 or NSMIA, allowing benefited large businesses, it had a more
Act, which added Section 13(k) 187 to
transactions to involve ‘‘covered limited effect on small businesses, the
the Exchange Act, prohibits public
securities’’ and (2) making NASDAQ securities of many of which trade on the
companies from extending personal
Capital Market and OTCBB stocks NASDAQ Capital Market and the
loans to directors or executive
‘‘covered securities,’’ thereby OTCBB and consequently do not qualify
186 Rule 502(a) provides in pertinent part: ‘‘Offers preempting most state securities for the favorable exemptive treatment
and sales that are made more than six months registration provisions. accorded ‘‘covered securities.’’ For these
before the start of a Regulation D offering or are In connection with its passage of
made more than six months after completion of a smaller public companies, the added
NSMIA, Congress authorized the SEC to
Regulation D offering will not be considered part of
that Regulation D offering, so long as during those
define the term ‘‘qualified purchaser’’ 190 Defining the Term ‘‘Qualified Purchaser’’
six month periods there are no offers or sales of under Securities Act Section 18 to Under the Securities Act, SEC Release No. 33–8041
securities by or for the issuer that are of the same include, among others, ‘‘sophisticated (Dec. 19, 2001) [66 FR 66839].
or a similar class as those offered or sold under investors, capable of protecting 191 See, e.g., Letter from Joseph P. Borg, NASAA
Regulation D, other than those offers or sales of President and Director, Alabama Securities
securities under an employee benefit plan as
themselves in a manner that renders
Commission, on behalf of the North American
defined in Rule 405 under the Act, 17 CFR regulation by state authorities Securities Administrators Association to Committee
230.405.’’ (Mar. 4, 2002), available at http://www.sec.gov/
187 15 U.S.C. 78m(k). 188 Pub. L. 107–04, § 402, 166 Stat. 745 (2002). rules/proposed/s72301.shtml.
187 17 CFR 230.405. 189 Pub. L. No. 104–290, 110 Stat. 3416 (1996). 192 Supra note 190, at 4.
burden, complexity and transaction capital with which to fund the IPO matters for auditors of public
costs that result from a need to comply process. companies.
with numerous sets of laws and Rule 152 provides an integration safe
harbor that protects against integration Accounting Standards—Primary
regulations, rather than just one, places
of a private offering followed closely by Recommendations
them at a distinct disadvantage in
comparison with their larger a registered public offering. By its terms, We recommend that the Commission
counterparts. the language of Rule 152 appears to and other bodies, as applicable,
In our view, the two-tiered regulatory require that an issuer ‘‘decide’’ to file for effectuate the following:
structure to which the NASDAQ Capital the public offering after the private Recommendation V.P.1
Market and OTCBB–traded securities offering.193 In other words, the safe
harbor protection from integration Develop a ‘‘safe-harbor’’ protocol for
are subject represents an unnecessary
would not appear to be available to an accounting for transactions that would
and duplicative level of regulation that
issuer that contemporaneously plans a protect well-intentioned preparers from
impedes the free flow of capital, while
private placement (for among other regulatory or legal action when the
adding little in terms of investor
reasons, to raise funds necessary to process is appropriately followed.
protection. All companies traded in This recommendation represents an
both markets are required to be sustain it through the IPO process) and
a subsequent registered offering. attempt by us to address the diminished
Exchange Act reporting companies. use of professional judgment caused in
Therefore, we recommend that the Moreover, Rule 152 does not apply to
private offerings undertaken pursuant to part by fears of second-guessing by
Securities Act Section 18(b) definition regulators and the plaintiff’s bar. This is
of ‘‘covered securities’’ be expanded to Rules 504 or 505, which are exempt
pursuant to Securities Act Section 3(b), a very serious issue for smaller public
include the shares of all NASDAQ companies. Testimony taken by us, as
Capital Market and OTCBB issuers, not Section 4(2) as set forth in the rule.
Although the staff of the Division of well as written communications we
provided that such companies (1) are received, strongly supported this view.
current in their Exchange Act filings Corporation Finance has indicated that
it does not interpret Rule 152 literally, Accounting standards for public
and (2) adhere to the corporate companies vary in nature, ranging from
governance standards, detailed in Part and will extend safe harbor treatment
even in cases where an issuer standards containing principles and
III of this Committee report, that implementation guidance on broad
companies would be required to observe concurrently plans a private placement
and registered offering,194 we believe accounting topics to those containing
in order to get relief from certain guidance pertaining to specific business
that it is time to clarify or amend the
requirements of Sarbanes-Oxley Act transactions or industry events. Even
language of the rule appropriately.
Section 404. We believe that this action with the broad spectrum of existing
would be consistent with the sentiment Part V. Accounting Standards accounting standards, transactions or
expressed in Securities Act Section We devoted a considerable amount of other business events frequently arise in
19(d), which mandates greater federal time and effort surveying the current practice for which there is no explicit
and state cooperation in securities state of U.S. GAAP that apply to smaller guidance. In these situations, public
matters in order to provide both public companies and certain of the companies and their auditors consider
maximum uniformity in federal and processes related to the audits of their other relevant accounting standards and
state regulatory standards and to financial statements. In general, we evaluate whether it would be
minimize interference with capital believe that current regulations and appropriate to apply the guidance in
formation. Further, investor protection processes in these areas serve smaller those standards by analogy. Preparers
would be preserved, as states would public companies and their investors often find it difficult to make these
retain their anti-fraud authority and the very well. We did, however, identify determinations, particularly in new or
SEC would maintain its supervisory role several concerns in this area which, we emerging areas. Even when accounting
through review of issuer registration acknowledge, are not all unique to guidance is applied by analogy,
statements and Exchange Act filings. smaller public companies. In decreasing questions frequently arise as to whether
A final word should be said order of concern, these areas are: the analogy is appropriate based on a
concerning the manner in which this • Complexity of current accounting company’s particular facts and
recommendation is implemented. standards; circumstances. The result is that
Although not entirely clear, it appears • Diminished use and acceptance of companies frequently end up adopting
that the express language of Section 18 professional judgment because of fears an approach dictated by their auditors,
may not provide the Commission with of being second-guessed by regulators which the companies believe is caused
the authority to expand the definition of and the plaintiffs bar; by their auditors’ concerns about
‘‘covered securities’’ to encompass • Perception of lack of choice in regulators questioning their judgments,
NASDAQ Capital Market and OTCBB selection of an audit firm; or for other reasons.
securities without further Congressional • Lack of judgment concerning In view of this situation, we are
action. In such event, we recommend application of auditor independence recommending that a ‘‘safe-harbor’’
that the Commission petition Congress rules; and protocol be developed that would
to enact legislative changes to Section • Lack of professional education protect well-intentioned preparers from
18 in order to effect such changes. requirements covering SEC reporting regulatory or legal action when a
Recommendation IV.S.12 193 Rule 152 provides as follows: ‘‘The phrase
prescribed process is appropriately
‘transactions by an issuer not involving any public followed and results in an accounting
Clarify the interpretation of or amend offering’ in Section 4(2) shall be deemed to apply conclusion that has a reasonable basis.
the language of the Rule 152 integration
to transactions not involving any public offering at A possible outline for the protocol for
safe harbor to permit a registered initial the time of said transaction although subsequently the preparer to follow would be as
public offering to commence thereto the issuer decides to make a public offering
and/or files a registration statement.’’ 17 CFR follows:
immediately after the completion of an 230.152. • Identify all relevant facts.
otherwise valid private offering the 194 See, e.g., SEC No Action Letter, Verticom, Inc. • Determine if there is appropriate
stated purpose of which was to raise (Feb. 12, 1986). ‘‘on-point’’ accounting guidance.
• If no on-point guidance exists, We believe that implementation of In some cases, a company will need
develop and timely document the this recommendation has the potential to gather and analyze a significant
preparer’s conceptual basis for their to assist smaller public companies when amount of information in order to adopt
conclusion as to the appropriate working with their audit firms and other an accounting standard. Smaller public
accounting treatment. parties involved in the financial companies oftentimes may not have the
• Determine and timely document reporting system. This, in turn, should resources of larger companies to assist
how the proposed accounting treatment reduce excessive and unnecessary with this effort.199 For example,
reflects the economic realities of the regulatory burdens on smaller public companies may not have sufficient
transaction. companies. information technology or valuation
• Disclose in the financial statements We do not believe that specialists on staff and would need to
and in Management’s Discussion & implementation of our recommendation consider hiring external parties. In
Analysis the nature of the transaction, would fully address the diminished use addition, as business transactions have
the possible alternative accounting of professional judgment due to fears of become more complex in recent years,
treatments, and the rationale for the being second-guessed. This is a deep accounting standards also have become
approach adopted. seated problem related to the excessive more complex, requiring greater study
litigiousness of our society.197 and expertise by the preparers and
We believe that a ‘‘safe harbor’’ auditors’ of financial statements.200
approach is suitable for dealing with Accordingly, we urge the Commission,
other regulators and federal and state We note that some of the more
this problem. In general, a safe harbor complicated accounting standards
provision in a law serves to excuse legislators to continue to search for
appropriate and effective ways to lessen recently issued by the FASB permit
liability if an attempt to comply in good private companies an extended period
faith can be demonstrated. Safe harbor this problem and reduce unnecessary
regulatory burdens on smaller of time in which to adopt the new
provisions are used in many areas of the standard.201 We believe that allowing
federal securities laws. One well-known companies.
microcap companies more time to
safe-harbor that may serve as a model Recommendation V.P.2 implement new accounting standards is
for crafting a safe-harbor for accounting In implementing new accounting appropriate. We are recommending that
transactions is the safe-harbor for standards, the FASB should permit microcap companies be allowed to
forward-looking statements under the microcap companies to apply the same apply the same effective dates that the
Private Securities Litigation Reform Act extended effective dates that it provides FASB provides for private companies in
of 1995. The PSRLA provides a safe for private companies. implementing new accounting
harbor from liability in private claims New accounting standards typically standards. The Committee considered
under the Securities Act and Exchange introduce new accounting requirements and rejected the notion that smallcap
Act to a reporting company, its officers, or change existing requirements. In companies, in addition to microcap
directors and employees, as well as order to allow sufficient time for companies, also should be allowed
underwriters, for projections and other companies to gather information extended effective dates. We believe
forward-looking information that later required by the new accounting that, in general, smallcap companies
prove to be inaccurate, if certain standards, the FASB does not require have more resources than microcap
conditions are met. The PSLRA’s safe- new standards to be effective companies and should be able to adopt
harbor was based on aspects of SEC immediately upon issuance. Instead, the new accounting standards on the same
Rule 175 under the Securities Act and FASB establishes a date in the future time line as larger public companies.
Rule 3b–6 under the Exchange Act.195 when the accounting standards should While making this recommendation,
Both of these rules, adopted in 1979, be adopted, or become effective. The we do not propose to establish different
provide a safe-harbor for certain amount of time allowed by the FASB accounting standards for smaller and
forward-looking statements published in between the issuance of a new standard larger public companies. Primarily
documents filed with the SEC, provided and its effective date varies and depends through our Accounting Standards
the filer had a reasonable basis to make on the nature of the accounting Subcommittee, we considered the so-
the statement and was acting in good requirements and the number of called Big GAAP versus Little GAAP
faith. By combining aspects of, but not companies impacted. In addition, the debate. This debate involves the
eliminating, Rules 175 and 3b–6 with FASB may establish different effective advisability of adopting two different
the judicially created ‘‘bespeaks dates for private companies and public accounting standards for smaller and
caution’’ doctrine, Congress created a companies.198 larger public companies, and whether
statutory safe-harbor based on the belief U.S. GAAP should be made scalable for
that the existing SEC rule-based and 3. The plaintiff fails to prove the statement was smaller public companies. The
judicial safe-harbor protections did not made with actual knowledge that it was materially
provide adequate protections to false or misleading. defined therein, see FASB Statement of Financial
reporting companies from abusive See Jay B. Kasner, The Safe Harbor for Forward- Accounting Standards No. 150, Accounting for
Looking Statements Under the Private Securities Certain Financial Instruments with Characteristics
private securities litigation.196 Litigation Reform Act of 1995, Practising Law of both Liabilities and Equity ¶ 29 (May 2003) and
Institute (Sept. 2000); See also Stephen J. Schulte FASB Staff Position 150–3 (Nov. 2003).
195 17 CFR 230.175, 240.3b–6. and Alan R. Glickman, Safe Harbors for Forward- 199 See Letter from Ernst & Young LLP to
196 The PSLRA provides a safe-harbor from Looking Statements: An Overview for the Committee (May 31, 2005); Letter from American
liability under the Securities Act and Exchange Act Practitioner, Practising Law Institute (Nov. 1997). Bankers Association to Committee (Aug. 31, 2005).
to the reporting company, its officers, directors, 197 See Record of Proceedings 95–100 (June 16, 200 See Letter from BDO Seidman, LLP to
employees and underwriters, if the forward-looking 2006) (statements of George Batavick, Adv. Comm. Committee (May 31, 2005).
statements later prove to be inaccurate, if: Observer, and Mark Jensen, Adv. Comm. Member, 201 See Statement 150, paragraph 29. See also
1. The forward-looking statement is identified as on the importance of tort reform to reduce litigation FASB Statement of Financial Accounting Standards
such and is accompanied with meaningful costs and facilitate a return to principles-based No. 123, Share-Based Payment § 69, B248 (revised
cautionary statements identifying important factors accounting). 2004) (permitting small business issuers, as defined,
that could cause actual results to differ materially; 198 FASB standards that distinguish between to defer adoption of the standard on the basis that
or private and public companies usually define those those companies may have fewer resources to
2. The forward-looking statement is immaterial; terms. For examples where the FASB has deferred devote to implementing new accounting standards
or the effective dates for non-public entities, as and thus may need additional time to do so).
Committee considered whether the materiality related to previously issued unwarranted. Two specific fact patterns
needs of users of smaller public financial statements. should be considered in developing
company financial statements are We heard testimony related to a additional guidance:
different from the needs of users of recent increase in financial statement • The effect of the previously
larger public company financial restatements for previously undetected undetected error is not material to any
statements, whether smaller public accounting errors.204 The Committee is prior annual or quarterly financial
companies incur disproportionate costs concerned that these restatements are statements, the effect of correcting the
to provide certain financial information, occurring where the impact of the error cumulative error is not expected to be
and whether such information is is not likely to be meaningful to a material to the current annual period,
actually used. The Committee discussed reasonable investor. The determination but the impact of correcting the
whether smaller public companies as to whether an event or transaction is cumulative error is material to the
should have accounting standards with material to the financial statements can current quarter’s financial statements. In
recognition, measurement and/or be highly subjective and judgmental. this circumstance, we recommend the
disclosure requirements that are One source of information for public SEC consider whether the appropriate
different from those of larger public companies to consider when making treatment would be to correct the
companies, and whether unintended this determination is SEC Staff cumulative error in the current period
adverse consequences would result from Accounting Bulletin No. 99, Materiality financial statements, with full and clear
having two sets of GAAP. (SAB 99). SAB 99 expresses the staff’s disclosure of the item and its impact on
We have determined that different views regarding reliance on certain the current quarter, with no restatement
accounting standards should not be quantitative benchmarks to assess of prior year or quarterly financial
created for smaller and larger public materiality in preparing financial statements. We believe this treatment is
companies. We believe such an statements and performing audits of consistent with the guidance in
approach would confuse investors and those financial statements. One issue paragraph 29 of Accounting Principles
that, in many cases, the financial that is not addressed in SAB 99 relates Board Opinion No. 28, Interim Financial
community would require smaller to the assessment of materiality in Reporting.205
public companies to follow the more quarterly reporting periods, including • The effect of a previously
stringent accounting standards quarterly reporting periods of undetected error is not material to the
applicable to larger companies. We previously reported annual periods. We financial statements for a prior annual
believe that if a two-tiered system of discussed whether one reason for these period, but is material to one or more of
accounting standards existed, many restatements might be the lack of the quarters within that year. In
smaller public companies would guidance pertaining to assessing addition, the impact of correcting the
voluntarily follow the more stringent materiality in quarterly periods. cumulative error in the current quarter’s
standards, so as not to be perceived as We recommend that the SEC consider financial statement would be material to
less sophisticated. We also believe that providing additional guidance for all the current quarter, but is not expected
two different accounting standards for public companies with respect to to be material to the current annual
public companies would add significant materiality related to previously issued period. In this circumstance, we
costs to the financial reporting system financial statements, to ensure that recommend the SEC consider whether
and could potentially increase the cost investor confidence in the U.S. capital the appropriate treatment would be the
of capital to smaller public companies, markets is not being adversely impacted same as described above since the
as risk premiums could attach to what by restatements that may be impact on the previously issued annual
might be perceived as less stringent financial statements is not material. In
accounting standards.202 Finally, we did 204 Record of Proceedings 30–31 (Sept. 19, 2005) this event, full disclosure in the current
not see evidence of any overwhelming (testimony of Lynn E. Turner, Managing Director of quarter financial statements should be
support for a two-tiered system of Research, Glass Lewis & Co., noting that Huron required.
Consulting Group reported that 75% of the
accounting standards in the written and restatements over the last five years have come from Recommendation V.P.4
oral submissions we received.203 small companies); Record of Proceedings 105 (Sept.
19, 2005) (testimony of Michael McConnell, Implement a de minimis exception in
Recommendation V.P.3 Managing Director, Shamrock Capital Advisors, the application of the SEC’s auditor
Consider additional guidance for all Burbank, Calif., citing several studies that show half independence rules.
to three quarters of the restatements of public The Commission’s rules on the
public companies with respect to companies in the last several years have been by
companies with either revenues under a half billion independence of public company
202 See, e.g., Letter from Council of Institutional
or market cap under $100 million). But see Record auditors include a general standard of
Investors to Committee (Aug. 26, 2005). of Proceedings 108 (Sept. 19, 2005) (statement of auditor independence.206 In
203 See Record of Proceedings 24–26, 42 (Oct. 14, Robert E. Robotti, Adv. Comm. Member, noting that determining whether a relationship or
2005) (testimony of Jane Adams, Maverick Capital the amount of restatements by smaller companies
Ltd., New York, New York, stating that companies is proportionate to that of larger companies, since provision of a service not specifically
by virtue of size should not be able to choose among microcap companies represent 50% of all public prohibited by the rules impairs the
multiple GAAP’s to structure transactions and keep companies). Institutional investor advisory firm auditor’s independence, four principles
relevant information from investors, and if different Glass, Lewis & Co. estimates that a record 1,200 of must be considered.207 The
standards are permitted, whether GAAP or internal the total 15,000 public companies will have
controls, any financial statements and filings announced accounting restatements by the time
205 The Accounting Principles Board (APB) was
prepared under this light version should warn annual reports are filed for 2005. This compares
investors that this information did not come with with 619 restatements in 2004, 514 in 2003, 330 in the predecessor entity to the FASB.
206 The most recent revision to the auditor
the full package of protections and controls). See 2002 and 270 in 2001, the year before the Sarbanes-
also Letter from PricewaterhouseCoopers LLP to Oxley Act was passed. The threat of criminal independence rules occurred in Jan. 2003. See
Committee (Sept. 2, 2005); Letter from Grace & penalties for executives and the focus on internal Strengthening the Commission’s Requirements
White, Inc. to Committee (Oct. 6, 2005); Letter from controls by the Sarbanes-Oxley Act has created an Regarding Auditor Independence, SEC Release No.
Glass Lewis & Co. to Committee (Sept. 14, 2005). environment of second-guessing by auditors, where 33–8183 (Jan. 28, 2003) (68 FR 6006).
See also responses to Questions 16 and 21 of minor accounting errors can now result in a full 207 See Remarks by Edmund W. Bailey, Senior
Request for Public Input by Advisory Committee on investigation of a company’s accounting Associate Chief Accountant, U.S. Securities and
Smaller Public Companies, SEC Release No. 33– procedures. Excavations in Accounting: To Monitor Exchange Commission, Before the 2005 AICPA
8599 (Aug. 5, 2005) available at http:// Internal Controls, Firms Dig Ever Deeper Into Their National Conference on Current SEC and PCAOB
www.sec.gov/rules/other/265-23survey.shtml. Books, Wash. Post, Jan. 30, 2006, at D1. Continued
Commission’s rules also set forth their need for significant assistance from affairs.212 A large concentration of both
specific prohibitions on financial, their auditors. large and small public companies is
employment, and business relationships As a separate matter, we audited by the Big Four audit firms.213
between an auditor and an audit client, acknowledged that the current auditor Notwithstanding that the Big Four audit
as well as prohibitions on an auditor independence rules do not provide firms have earned a well-deserved
providing certain non-audit services to relief for violations of the rules based on reputation of expertise in auditing
an audit client, and augment the general materiality considerations. As a result, public companies, we heard testimony
standard and related principles.208 One we believe that a seemingly from several non-Big Four audit firms
of the principles is that an auditor insignificant violation of the auditor that indicated that they too are capable
cannot audit his or her own work. The independence rules could have of serving smaller public companies.214
Committee considered whether the significant consequences.210 These
212 One witness testified that smaller public
current auditor independence rules consequences could require a company
companies are having trouble timely filing their
should be modified for smaller public to immediately change audit firms, to annual and quarterly reports with the SEC, because
companies to make it clear that an declare its previous filings invalid and the Big Four audit firms are dropping them as
auditor may provide some assistance. to engage an audit firm to re-audit its clients, generally because they fall outside the Big
In May 2005, the Commission issued Four’s profiles for acceptable risk. Record of
prior financial statements, creating Proceedings 12 (June 17, 2006) (testimony of
a statement related to internal control significant cost and disruption to the Edward S. Knight, Executive Vice President and
reporting requirements that also company and its stockholders. The General Counsel, NASDAQ Stock Market, Inc.).
discussed this issue.209 The Committee therefore recommends that Another witness testified that, due to changes in the
Commission stated that as long as accounting industry resulting from the Sarbanes-
the SEC examine its independence rules Oxley Act and consequent pressure from
management makes the final and consider establishing a rule institutional and retail investors, increasing
determination regarding the accounting provision that provides relief for certain importance has been placed on using a Big Four
to be used for a transaction and does not firm. As a result, smaller public companies, who are
types of violations that are de minimis the least prepared to negotiate, are increasingly
rely on the auditor to design or in nature as long as these are discussed facing oligopolies, resulting in a disruption in the
implement internal controls related to with and approved by the company’s normally balanced relationship between a company
that accounting, it did not believe that audit committee.211 and its accounting firm. Young smaller public
the auditor’s providing advice or companies are now in constant fear that their
Accounting Standards—Secondary auditors will either increase their audit fees or
assistance, in itself, constitutes a abandon them because of the pressure on the
violation of the independence rules. The Recommendations auditing firm to obtain more profitable business
Committee considered whether this In addition to the foregoing primary from larger companies. He recommended that
emphasis be placed on the acceptability of more
guidance would enable an auditor to accounting standards recommendations, regional accounting firms for use by smaller public
provide assistance to smaller public we also submit for the Commission’s companies, as well as the establishment or
company related to new and/or consideration the following secondary encouragement of a fifth or sixth Big Four audit
complicated accounting standards or firm to restore a more appropriate balance between
recommendations: accounting firms and their client companies in
with unusual/complicated transactions. order to contain costs and at the same time provide
Ultimately, we concluded that no Recommendation V.S.1 an alternative audit firm that is generally accepted
modification to the Commission’s Together with the PCAOB and the
by the investment community. Record of
independence rules is warranted with Proceedings 32–33, 37–38 (June 17, 2005)
FASB, promote competition and reduce (testimony of Alan Patricof, Co-Founder, Apax
respect to auditors providing assistance the perception of the lack of choice in Partners). See also Remarks by Christopher Cox,
to smaller public companies. In making selecting audit firms by using their Chairman, U.S. Securities and Exchange
this recommendation, we noted the Commission, Before the 2005 AICPA National
influence to include non-Big Four firms Conference on Current SEC and PCAOB
principle that auditors should not audit in committees, public forums, and other Developments (Dec. 5, 2005) (stating that
their own work and believe this basic venues that would increase the competition is essential for the proper functioning
premise is critical to ensuring auditor awareness of these firms in the of any market, and a broader and more competitive
independence and the resulting market for audit services should be encouraged).
marketplace. 213 See United States General Accounting Office,
confidence of investors in the financial
statements of all companies, including This recommendation represents our Report to the Senate Committee on Banking,
Housing, and Urban Affairs and the House
smaller public companies. The best attempt to deal with the very Committee on Financial Services, Public
Committee concluded that a separate set serious problem of the lack of Accounting Firms, Mandated Study on
of auditor independence rules for larger competition in the auditing industry, Consolidation and Competition (GAO–03–864)
stemming in large part from market (July 2003).
and smaller publicly-held companies 214 Record of Proceedings 19 (Sept. 19, 2005)
would be inappropriate. We believe that concentration. Smaller companies are (testimony of Richard Ueltschy, Executive, Crowe
our recommendation to apply the same seriously harmed by this state of Chizek and Company, LLC) (‘‘[S]maller public
companies, virtually all of them could be served
extended effective dates for microcap adequately by more than the Big Four, certainly the
210 One witness testified that audit firms are
companies that the FASB provides for somewhat paranoid about violating these
eight largest firms that are subject to annual review
private companies will help serve to independent rules and rightfully so. The SEC and
by the PCAOB. And, in fact, many of those smaller
public companies could also be effectively served
alleviate the pressure and costs to PCAOB need to go further to provide very clear
by the dozens of qualified regional C.P.A. firms.’’);
microcap companies in implementing guidelines for audit firms as to what they can do
Record of Proceedings 129, 130–133 (Aug. 9, 2005)
and cannot do. In order to facilitate audit firms
new accounting standards and reduce assist smaller public companies with their SEC
(testimony of Bill Travis, Managing Partner,
McGladrey & Pullen LLP, commenting that his firm,
reporting, some degree of proportionality in as well as many other second-tier non-Big Four
Developments (‘‘Bailey 2005 AICPA Remarks’’) limiting the amount of the penalty for an audit firms, have a level of expertise and resource
(discussing principles regarding auditor inadvertent violation of the auditor independence capabilities that can certainly serve the needs of
independence). rules should be used. Record of Proceedings 14 very large mid-market companies with global
208 See Preliminary Note to Rule 2–01 of (Aug. 9, 2005) (testimony of Mark Schroeder, Chief facilities around the world, as well as a much
Regulation S–X and Item 201(c)(4) of Regulation S– Executive Officer, German American Bancorp). greater percentage of small and mid-size publicly-
X, 17 CFR 210.2–01(c)(4); Exchange Act Section 211 See Bailey 2005 AICPA Remarks (discussing
traded companies). See also Record of Proceedings
10A(g). some of the information considered by the SEC 92 (Oct. 14, 2005) (testimony of Gerald I. White,
209 See Commission Statement on Office of the Chief Accountant when making Grace & White, Inc., New York, New York) (‘‘I don’t
Implementation of Internal Control Reporting assessments regarding the impact of an see any evidence that the large firms do any better
Requirements, May 16, 2005. independence rules violation). job than the small ones.’’).
The PCAOB has registered and oversees We nevertheless believe that efforts to This complexity disproportionately
over 900 U.S. public audit firms. The promote competition in the auditing impacts smaller public companies due
experience of some of our members, as industry and educate registrants in the to their lack of resources. Complexity is
well as submissions made to us, choice of selecting audit firms is created because of:
confirms a trend for smaller public essential to maintain pricing discipline • An unfriendly legal and
companies to consider options other and to address the perceived lack of enforcement environment that
than the Big Four audit firms.215 More competition in the auditing industry. diminishes the use and acceptance of
encouragement should be given to audit We are therefore recommending that the professional judgment in today’s
committees and underwriters to SEC, the PCAOB promote competition financial reporting system because of
seriously consider engaging a non-Big among audit firms and that the FASB fears of second-guessing by regulators
Four audit firm. We believe that market further this effort by ensuring that non- and the plaintiff’s bar.220
forces ultimately will determine which Big Four firms are included in • Development of complex business
firms will audit public companies. We committees, public forums, and other arrangements and accounting-motivated
recognize the Commission’s, the venues that would increase the transactions.221
PCAOB’s and the FASB’s limited awareness of these firms in the • Constituent concerns about
authority to affect concentration in the marketplace.217 earnings volatility and desire for
auditing industry. We also recognize industry-specific guidance and
Recommendation V.S.2
that some of our recommendations exceptions.222
concerning internal control may Formally encourage the FASB to • Frequent requests by preparers and
increase the concentration of smaller continue to pursue objectives-based auditors for detailed accounting
public companies with revenues over accounting standards.218 In addition, guidance to limit potential
$250 million who are audited by the Big simplicity and the ease of application inconsistencies in the application of
Four.216 should be important considerations accounting standards and second-
when new accounting standards are guessing by the legal community and
215 One witness testified that, although the bottom established. enforcement authorities.223
line is whether audit committees and investment This recommendation is an attempt to Certain accounting standards create
banks are willing to advise choosing a non-Big Four deal with the issue of excessive complexity because:
firm, current market conditions are fortunately complexity in accounting standards.219
driving some changes in the industry out of
220 One witness encouraged a move towards more
necessity. Big Four firms have limited resources
and are allocating their resources to wherever the recommendations will further concentrate audit of a principles-based and a judgment-based
best use of those resources may be used by their services of public companies with the Big 4 audit approach to accounting so that competent people
major clients. Non-Big Four firms are benefiting firms and suggesting that the SEC take further on the audit committees, in management and in the
from this market development in that very high measures to ensure that there is no further audit audit firms can work together to use their respective
quality public companies have to go find other non- concentration of audit services in the United intellect, judgment and knowledge of the business
Big Four firms to do their audits. Accordingly, he States). to determine where best to spend their time each
indicated that firms like his are receiving many 217 See, e.g., Record of Proceedings 84 (June 17, year, in such areas, for example, as internal control
inquiries as to whether they are capable of doing 2005) (testimony of Wayne A. Kolins, National compliance with Section 404 of the Sarbanes-Oxley
the work, and are in fact winning the work, Director of Assurance and Chairman of the Board, Act. He commented that all the guidance provided
including such firms as Grant Thornton, LLP and BDO Seidman, LLP, encouraging the use of so far by the SEC and the PCAOB on the use of
BDO Seidman, LLP. Accordingly, he believes that symposiums, whereby the CEO’s and CFO’s of professional judgment is tempered, however, by the
market conditions are doing a lot more to win work smaller public companies meet to discuss their current uncertainty as to what will be the
for the non-Big Four audit firms than any marketing experiences using non-Big Four audit firms); Record expectations of company management, the audit
communications could have done. See Record of of Proceedings 130 (Aug. 9, 2005) (testimony of Bill committee and the auditor once there is a major
Proceedings 130–131 (Aug. 9, 2005) (testimony of Travis, Managing Partner, McGladrey & Pullen LLP, failure due to an unintended mistake reported in
Bill Travis, Managing Partner, McGladrey & Pullen encouraging non-Big Four audit firms to become the system. Until we see the results of such a
LLP). See also Record of Proceedings 19 (Sept. 19, more active with regulatory organizations like the mistake, he believes there will continue to be
2005) (testimony of Richard Ueltschy, Executive, PCAOB and SEC and others to build awareness of conservatism in the practice of audit firms,
Crowe Chizek and Company, LLC) (‘‘We are seeing the capabilities of the non-Big Four audit firms); management teams and audit committees. Record of
today many companies at * * * the smaller end of Record of Proceedings 63–64, 82–83 (June 17, 2005) Proceedings 117–118 (Aug. 9, 2005) (testimony of
the large company classification, as this group’s (testimony of Alan Patricof, Co-Founder, Apax Bill Travis, Managing Partner, McGladrey & Pullen
defined it, that are now choosing to look outside the Partners, recommending that regulatory bodies use LLP).
Big Four for their audit services. And they’re doing the bully pulpit and moral suasion to increase 221 The SEC Staff’s report entitled Report and
so largely because of an attempt to introduce a bit awareness and acceptance of the good quality of Recommendations Pursuant to Section 401(c) of the
of market competition into the pricing for the regional non-Big Four auditing firms, including Sarbanes-Oxley Act of 2002 On Arrangements with
service. * * * [T]here’s a fair amount of activity in encouraging investment banking firms to rely upon Off-Balance Sheet Implications, Special Purpose
terms of auditor change, there’s real price these non-Big Four firms). Entities, and Transparency of Filings by Issuers
competition being introduced into that process.’’); 218 See SEC Staff’s Study Pursuant to Section (‘‘Off-Balance Sheet Staff Study’’), released in June
Record of Proceedings 92 (Oct. 14, 2005) (testimony 108(d) of the Sarbanes-Oxley Act of 2002 on the 2005, refers to an accounting-motivated structured
of Gerald I. White, Grace & White, Inc., New York, Adoption by the United States Financial Reporting transaction as a transaction structured in an attempt
New York) (‘‘[S]maller firms seem to be clearly System of a Principles-Based Accounting System, to achieve reporting results that are not consistent
gravitating away from the largest auditors to smaller released in July 2003 (‘‘Principles-Based with the economics of the transaction. As an
auditors. And I suspect that not just audit costs, but Accounting System Staff Study’’) (‘‘objectives- example, the report cites to the restructuring of
404 costs are driving that process.’’). oriented’’ standards are distinguished from lease arrangements to avoid the recognition of
216 See Letter from Crowe Chizek and Company ‘‘principles-based’’ or ‘‘rules-based’’ standards). liabilities on the balance sheet following the
LLC to Committee (Feb. 20, 2006), available at 219 See Remarks by Robert H. Herz, Chairman, issuance of the FASB’s Statement No. 13,
http://www.sec.gov/rules/other/265–23/ Financial Accounting Standards Board, Before the Accounting for Leases, released in 1976.
222 See Principles-Based Accounting System Staff
mhildebrand022006.pdf (‘‘Removing the auditor 2005 AICPA National Conference on Current SEC
involvement requirement for Smallcap companies and PCAOB Developments (Dec. 6, Study (listing three of the more commonly-accepted
will cause firms other than the Big Four to have 2005)(discussing the complexity in financial shortcomings of rules-based standards, such as
very few internal control audit clients * * * This reporting). See also Remarks by Christopher Cox, numerous bright-line tests, exceptions to principles
will create a large, unintended competitive Chairman, U.S. Securities and Exchange underlying the accounting standards, and
advantage to the Big Four and foster further Commission, Before the 2005 AICPA National complexity in and uncertainty about the application
consolidation in the audit profession.’’) and Letter Conference on Current SEC and PCAOB of a standard reflected in the demand for detailed
from McGladrey and Pullen LLP to Committee (Feb. Developments (Dec. 5, 2005); Remarks by Scott A. implementation guidance).
21, 2006), available at http://www.sec.gov/rules/ Taub, Acting Chief Accountant, U.S. Securities and 223 Id. See also FASB Staff Position No. 123(R)–
other/265–23/btravis022106.pdf (supporting the Exchange Commission, Before the 2005 AICPA 2, Practical Accommodation to the Application of
efforts of the Advisory Committee but expressing National Conference on Current SEC and PCAOB Grant Date as Defined in FASB Statement No.
concern that the Committee’s Section 404 Developments (Dec. 5, 2005). 123(R) (Oct. 18, 2005).
• The lack of a fully developed on smaller public companies, as well as certain common themes in those
conceptual framework leads to larger public companies, while standards that could be used to develop
inconsistent concepts and principles improving the quality of financial recommendations regarding accounting
being applied across accounting reporting. pronouncements.
standards.224 We commend the efforts of the SEC In reviewing existing accounting
• Scopes in standards are at times and FASB to pursue ‘‘objectives-based standards, we considered the effect of
unclear and may contain exceptions.225 accounting standards,’’ as this should their measurement and disclosure
• The standards have different help to reduce complexity.231 The requirements on smaller public
measurement attributes (such as Committee recognizes that success will companies. The Committee also
historical cost versus fair value) and require preparers, financial advisors and considered possible screening criteria
treatment alternatives.226 auditors to apply the intent of the rules that could be used to determine whether
• Rules and bright-line standards to specific transactions rather than using an accounting standard should be
provide opportunities for accounting- ‘‘bright-line’’ interpretations to achieve modified for smaller public companies.
motivated transactions that are not a more desirable accounting treatment. The objective of our efforts was to
necessarily driven by economics.227 The Committee also believes that determine whether for certain
• The standards themselves have simplicity and the ease of application of accounting standards, the information is
become extremely lengthy and difficult accounting standards should be very costly for a small business to
to read.228 important considerations when new, prepare and yet the information is not
Additional complexity in accounting being utilized by its investors or other
conceptually-sound accounting
standards also comes about because: users of its financial statements.
• In prior years, multiple parties set standards are established. Success will
also require regulators and the courts to After deliberating these questions, we
standards, such as the SEC, the FASB, unanimously concluded that, since we
the AICPA, the Accounting Principles accept good faith judgments in the
application of objectives-based believe it is inappropriate to create
Board (APB), and the Emerging Issues different standards of accounting for
Task Force (EITF). accounting standards. We believe these
goals will only be accomplished by smaller public companies (i.e., Big
• Differing views exist on the GAAP versus Little GAAP), we should
application of fair value measurement long-term changes in culture versus
short-term changes in regulations. This not propose recommendations to modify
techniques and models.229 existing accounting standards for
• Phased projects produce only will allow for greater consistency and
comparability between financial smaller public companies.
interim changes.230 In sum, we agreed that the current
We believe that the current financial statements.
financial reporting environment could
reporting environment could be Accordingly, we offer the following
be improved to reduce the reporting
modified to reduce the reporting burden suggestions aimed at simplifying future
burden on both smaller public
accounting standards:
224 For example, related to the accounting for • There should be fewer (or no) companies, as well as for larger public
revenue transactions, FASB Statement of Concepts exceptions for special interests. companies, while improving the quality
No. 5, Recognition and Measurement in Financial • Industry and other considerations of financial reporting. In this light, we
Statements of Business Enterprises, states that
that do not necessarily apply to a broad formulated the above recommendation
revenues are not recognized until earned. FASB to have the SEC formally encourage the
Statement of Concepts No. 6, Elements of Financial array of companies should be addressed
Statements, defines revenues as inflows or other by FASB staff positions rather than in FASB to continue to pursue objectives-
enhancements of assets or liabilities. The FASB FASB statements. based accounting standards. The
currently has a revenue recognition project on its
• FASB statements should attempt to Committee also recommended that
agenda designed in part to eliminate this simplicity and the ease of application
inconsistency. The FASB also has on its agenda a reduce or eliminate ‘‘bright-line tests’’
joint project with the International Accounting in accounting standards, and in cases should be key considerations when
Standards Board to develop a common conceptual where the standard-setter intends that a establishing new conceptually-sound
framework that is complete and internally
‘‘bright-line’’ test be applied make that accounting standards.
consistent.
225 For example, FASB Interpretation No. 45, clear in the guidance. Recommendation V.S.3
Guarantor’s Accounting and Disclosure The Committee is making this Require the PCAOB to consider
Requirements for Guarantees, Including Indirect recommendation in lieu of
Guarantees of Indebtedness of Others, clarifies the minimum annual continuing
scope of FASB Statement No. 5, Accounting for
recommending modifications to certain professional education requirements
Contingencies. This interpretation excludes certain existing accounting standards for covering topics specific to SEC matters
guarantees from its scope and also excludes other smaller public companies. Primarily for firms that wish to practice before the
guarantees from the initial recognition and through our Accounting Standards
measurement provisions of the interpretation. SEC.
226 See, e.g., FASB Statement No. 115, Accounting
Subcommittee, we identified certain Of the 939 U.S. audit firms registered
for Certain Investments in Debt and Equity accounting standards where with the PCAOB, we noted that
Securities (providing classification alternatives for modifications might be considered in approximately 82% of them audit five
investments in debt and equity securities, resulting the future for smaller public companies. or fewer public companies. We believe
in different measurement alternatives). The Committee recognized that smaller
227 See Off-Balance Sheet Staff Study. that continuing professional education
228 See, e.g., FASB Statement No. 133, Accounting
public companies, as well as larger pertaining to SEC-related topics would
for Derivative Instruments and Hedging Activities public companies, struggle with the be useful to the professional personnel
(June 1998) (exceeding 800 pages of authoritative application of certain accounting of registered firms, especially for those
guidance and over 180 implementation and standards, such as FASB Interpretation firms that do not audit many public
interpretive issues). No. 46 (revised December 2003),
229 The FASB currently has a project on its companies and for which this training
Consolidation of Variable Interest would improve their ability to serve
agenda to provide guidance regarding the

application of the fair value measurement objective Entities. The Committee also looked for public companies. While several
in generally accepted accounting principles. different groups and governmental
230 For example, FASB Statement No. 150 is part 231 See, e.g., SEC Staff Study, The Principles-
of the FASB’s broad project on financial Based Accounting System. See also FASB Response
bodies, such as the individual state
instruments that was added to the FASB’s agenda to SEC Study on the Adoption of a Principles-Based licensing boards, establish continuing
in 1986. Accounting System (June 2004). professional education requirements for
accountants, the PCAOB does not noted that the PCAOB and the SEC had the implementation of Section 404 and
currently have any minimum annual issued guidance in May 2005 regarding the interaction between an auditor and
training standards for registered firms’ its client.234
partners and employees who serve auditors will be reduced and the willingness of It appears that audit firms are starting
public companies. The Committee auditors to use their professional judgment will to become more comfortable with the
increase); Record of Proceedings 9–18, 56 (Oct. 14,
suggests, therefore, that minimum 2005) (testimony of Thomas A. Russo, Russo &
idea that it is acceptable to advise their
annual SEC training requirements be Gardner, Lancaster, Penn., describing a very stark clients with respect to new accounting
established for applicable partners and tension growing between companies and their standards and/or complicated
employees of audit firms registered with auditors, due to the lack of PCAOB Section 404 transactions, consistent with the
guidelines which has resulted in a zero percent sort
the PCAOB. of materiality test as auditors are unwilling to
guidance issued by the PCAOB and
exercise judgment, but rather go to the end of the SEC, while remaining fully cognizant of
Recommendation V.S.4 earth to confirm the integrity of control systems); the need for company management to
Monitor the state of interactions Record of Proceedings 57, 61 (Sept. 19, 2005) take full responsibility for its financial
between auditors and their clients in (testimony of Kenneth Hahn, Senior Vice President,
Chief Financial Officer, Borland Software Corp.,
statements and the underlying decisions
evaluating internal controls over Cupertino, Calif., commenting that the dynamics of on the application of accounting
financial reporting and take further risk make it virtually impossible for the control principles. We recommend that the SEC
action to improve the situation if portion of Section 404 to be cost effective for small and the PCAOB remain vigilant in
warranted. and mid-size companies, as both auditors and
boards will make the decision to over-engineer the
monitoring the impact of its guidance
The recent implementation of testing of a company’s internal control systems); through the Spring of 2006 reporting
Sarbanes-Oxley Act Section 404 by Record of Proceedings 100 (June 17, 2005) season. If the guidance is being
certain public companies has raised (testimony of Prof. William J. Carney, Emory appropriately applied, no further action
many questions and issues. One issue University School of Law, referring to a study
indicating that auditing fees have increased by as
with respect to the interaction of the
that has been identified pertains to the much as 58%, due to the increased costs associated auditor and its clients would be
adverse impact Section 404 has had on with the new requirements of the Sarbanes-Oxley required, except for implementation of
the relationship between audit firms Act). But see Record of Proceedings 33–34 and 41 our recommendation on implementing a
and the management of smaller public (Sept. 19, 2005) (testimony of Lynn E. Turner,
Managing Director of Research, Glass Lewis & Co.,
de minimis exception for certain
companies and the nature and extent of predicting the costs of Section 404 internal controls immaterial violations of the SEC’s
their communications on accounting to come down after the first year of implementation, independence rules.
and financial reporting matters.232 We and commenting that both in-house accountants
noted the substantial amount of and external auditors are working together to make Part VI. Epilogue
the implementation of Section 404 internal controls
testimony on this issue.233 We also for smaller companies much more difficult than [Content of Part VI To Be Included in
warranted); Record of Proceedings 18–19 (Sept. 19, Final Report.]
232 The SEC Staff’s Statement on Management’s 2005) (testimony of Richard Ueltschy, Executive,
Report on Internal Control Over Financial Crowe Chizek and Company, LLC, anticipating Part VII. Separate Statement of Mr.
Reporting, released in May 2005, stated that costs to implement Section 404 internal controls for Jensen
feedback from both auditors and registrants the second year to fall, and noting that auditors are
revealed that one potential unintended now willing to provide fixed fee quotes both for Introduction
consequence of implementing Section 404 and smaller public companies in their second year of
Auditing Standard No. 2, An Audit of Internal 404 implementation, as well as for new accelerated I am dissenting to recommendations
Control Over Financial Reporting Performed in filers undertaking their fist year of 404 III.P.1, III.P.2 and III.P.3 contained in
Conjunction with An Audit of Financial Statements, implementation); Record of Proceedings 106 (Sept. the Final Report of the Advisory
has been a chilling effect in the level and extent of 19, 2005) (testimony of Michael McConnell,
Managing Director, Shamrock Capital Advisors,
Committee. Since the time of the
communications between auditors and management
regarding accounting and financial reporting issues. Burbank, Calif., indicating that most investors, original vote on the recommendations, I
233 One witness commented that audit firms are including both direct investors and institutional have become aware that certain investor
too fearful to provide guidance and advice to any capital, do not have a problem with the costs of groups are concerned with the removal
inquiry by a public client, as such inquiry could be Section 404, as opposed to the capital raising
agency community, such as the lawyers, bankers
of Section 404 of the Sarbanes-Oxley
interpreted as an admission of an internal control
weakness by the company in that area. Although he and managers, that are uncomfortable in general Act of 2002 requirements for a large
recognizes that auditing firms cannot provide non- with any heightened standards of accountability). number of public companies. While no
audit services to their clients, he believes that they One witness testified that several public equity one knows the exact extent of investor
should be able to point their clients in the right offerings in which he was involved experienced
unprecedented delays due to the inability or
opposition, I believe this group is too
direction so that the client can do the work. He
indicated that audit firms are unclear as to where unwillingness of the auditors to provide timely important to the health of our capital
the line of auditor independence is drawn. As a responses during the registration process with the markets to ignore their point of view.
result, when in doubt, audit firms take the safe SEC. He believes that auditors can no longer be Specifically, I believe that providing a
route and do nothing out of fear that if they cross looked to for advice on how to handle various permanent exemption for smaller public
the line, they will put the entire audit firm at risk. issues, as it seems that almost every issue now
Record of Proceedings 24 (Aug. 9, 2005) (testimony needs to be ‘‘run through the national office’’ of the companies from these requirements may
of Mark Schroeder, Chief Executive Officer, German auditor. He notes that as auditor responses may ultimately harm investors of those
American Bancorp.). Similarly, another witness now take weeks longer to be produced than was the companies. In addition, I disagree with
testified that auditors and audit committees are too case a couple of years ago, he believes such delays the adoption of a weakened auditing
fearful of lawsuits to rely upon their judgment in leave potential issuers subject to additional market
implementing Section 404 internal controls. He risk that did not exist in the past. Record of standard for Section 404 compliance by
believes explicit common sense standards applied Proceedings 176 (Aug. 9, 2005) (testimony of James certain companies.
universally to all companies of a given size need P. Hickey, Principal, Co-Head of Technology Group, The fact that the Advisory Committee
to be developed by the regulators to indicate clearly William Blair & Company). See also Record of heard so many different points of view
what the auditors need to cover, and what the Proceedings 33 (June 17, 2005) (testimony of Alan
materiality levels are. Record of Proceedings 189 Patricof, Co-Founder, Apax Partners, explaining on these critical issues supports the fact
(Aug. 9, 2005) (testimony of James P. Hickey, that an unnatural relationship has developed that we do not yet have sufficient
Principal, Co-Head of Technology Group, William between companies and their auditors as experience with implementation of
Blair & Co.). See also Record of Proceedings 126– accountants have become more gun shy about Section 404 to know with certainty that
127, 139 (August 9, 2005) (testimony of Bill Travis, taking a risk-focused approach to their audit and
Managing Partner, McGladrey & Pullen LLP, express concerns about the pressure to comply with a permanent exemption is a better
commenting that once there is greater consistency PCAOB requirements which has caused the
and clarification on what is expected by the PCAOB relationship between auditors and companies to go 234 See SEC Statement on Implementation of
and its inspectors with regard to Auditing Standard from one of cooperation and consultation to that of Internal Control Reporting Requirements, May 16,
No. 2, the time, effort and costs incurred by the an adversarial nature). 2005.
answer, or whether any change in The key is to balance the needs of the capitalization and revenue criteria in
auditing standards is warranted. In light users of financial statements with the recommendations III.P.1 and 2. On this
of these factors, my recommendation costs to companies in supplying the latter point, the SEC would have to
calls for additional temporary deferrals required information. Balancing what weigh the implications of this proposal
coupled with a study of key preparers of financial statements can with the likelihood that many of the
implementation elements and a reasonably provide and what users of companies already complying would
definitive timetable for resolution. financial statements can reasonably nonetheless choose to continue to
expect to receive is a basic principle of comply.
Dissenting Views and Rationale The steps that I would propose would
our financial reporting and regulatory
I agree with the rationale in the Final systems. The current debate around be subject to a defined timeline and a
Report describing the need to scale Section 404 demonstrates clearly that set of actions to definitively resolve the
securities regulation for smaller this required balance does not exist at scope of Section 404 implementation for
companies. As a member of the smaller public companies today. Many smaller public companies prior to the
Advisory Committee I heard testimony smaller public companies have 2008 year-end. For example, these
from many on the potentially damaging indicated that the solution to this actions could include:
impact of the costs of Section 404 on the problem is to eliminate their • Reconsideration of the end product
growth potential of smaller public compliance with Section 404. However, in the ongoing process to tailor the
companies. Additionally, many parties simply eliminating the requirement will COSO requirements for smaller
provided written comment on the tip the scales and investors, who will businesses. This project has been
disproportionate burden of Section 404 not receive the information and underway for some time. It is essential
related costs on smaller public assurances intended to be provided that the final document succeed in
companies. The Final Report includes a under the Act, will likely believe that being truly useful to smaller companies.
number of examples and anecdotes on the system is out of balance to their It is vitally important that the final
the reasons for this disproportionate detriment. I believe that through document be replete with guidance,
burden including constraints caused by additional implementation experience, examples and tools, which permit the
limited internal and external resources, guidance and tools, Section 404 efficient implementation and testing of
lack of guidance tailored to smaller reporting can become more efficient and COSO requirements for smaller
companies and less revenue with which cost-effective for smaller public businesses. A definitive guide for
to offset implementation and ongoing companies. performing management’s assessment of
compliance costs. I acknowledge that I disagree with the adoption of an internal control effectiveness for smaller
this cost issue necessitates a significant alternative auditing standard. A lesser public companies would be the single
and substantial effort to develop an standard may prove not to be in the most useful element of this effort.
appropriate application of Auditing interest of the smaller public company • The conduct of an SEC-led pilot
Standard No. 2 in the small public as it creates a two tier system. The program for a prescribed number of
company environment. existence of a two tiered system could micro-cap and smaller public
I am also cognizant of testimony and reduce investor confidence in the companies during 2006 that would
written comments the Committee smaller public companies’ financial serve as a field test and lead to the
received on the significant benefits of reporting process and would thereby development of guidance on application
Section 404. Many reminded the eliminate all of the benefits of Section of AS2 in that environment for auditors,
Advisory Committee of the corporate 404 which, as discussed above, may be as well as the development of internal
failures that resulted in Congress an important benefit that could be control and Section 404 compliance
enacting the Sarbanes-Oxley Act of derived by smaller public companies. I tools for management of micro-cap and
2002. Other investors gave testimony on believe that effective Section 404 smaller public companies.
the benefits of Section 404 both to compliance in the smaller public • An in-depth study of the companies
themselves and to the companies in company will continue to improve that have two years of experience in
which they invest and the increased investor confidence and I also strongly complying with Section 404, perhaps by
confidence instilled in the investor believe that compliance can be achieved focusing on the smaller of the
community as a result of the additional in a cost effective manner. complying companies in order to gain
checks and balances required by the an in depth understanding of the costs
Act. A smaller public company, as Further Consideration and benefits. The criticality of reliable,
information provided to the Advisory Accordingly, in lieu of permanent not anecdotal, cost-benefit information
Committee indicates, is more likely to exemptions, I recommend an additional is a fundamental predicate to finalizing
suffer control deficiencies than a larger temporary deferral of the Section 404 the important regulatory and public
company. This fact logically means that reporting for non-accelerated filers that policy decisions that the SEC needs to
investors will consider their investment have not yet reported under Section make.
in smaller public companies a higher 404, coupled with a definitive action The basic timeline for this action plan
risk. It seems, therefore, that smaller plan led by the SEC as outlined below. could be: Pilot program and study in
public companies could benefit from a This plan includes participation by 2006, develop and field test guidance
process that improves investor smaller public companies, the auditing and rules in 2007, and implement in
confidence in their financial reporting profession and the PCAOB. Given the 2008.
thereby helping them achieve a wider cost concerns provided to the Advisory Should this recommendation be
and more diverse investor base. If such Committee on smaller public adopted, my firm would be willing
benefits for both companies and companies, such an additional dedicate resources to participate in any
investors can be derived from Section temporary deferral could include an efforts to gather evidence, field test new
404, then it seems to me that optional, temporary suspension of guidance, or develop tools for
eliminating the requirement for these certain of the requirements for smaller management and auditors that will
companies is unwarranted. Rather, more public companies that recently further support this process. We would
effort should be expended to scale the implemented the Section 404 look forward to working with others in
approach to smaller public companies. requirements and meet the market the accounting profession, vendors of
technology solutions, and companies in issue. While minimization of regulatory resource drain of Section 404 through
the program and other public and costs is always a desirable goal, the better implementation. The second is
private-sector organizations to achieve Report confirms what we knew coming providing small companies with an
success in this endeavor. into this Committee process, that the exemption from the main requirements
It is important to note that this costs have exceeded all estimates, and of Section 404.
timeline includes only one additional have significantly impacted small The objectives of cost control and
annual deferral of the Section 404 companies. There have been numerous investor protection need not be
requirements for non-accelerated filers; cost studies and other anecdotal mutually exclusive. However, the
however, it should also include specific, comments on whether these costs are, or Report’s primary recommendations
defined steps during this period, to will be, coming down in subsequent make them so. Our strongest objection is
significantly improve guidance and years. The evidence will only be clear that the Report recommends a flat-out
tools, and increase the cost effectiveness once we have actual data in the coming exemption from all auditor 404
of implementation for smaller public months. For many companies that have involvement in reviewing and
companies. yet to go through the process, the initial confirming internal controls. This is not
This recommendation is made with costs will be high. But the analysis must for just a few, but for what will
our mutual public interest goals in not end there. It suggests that whatever effectively be more than 70 to 80
mind. It reflects my opinion that after the benefits of Section 404 might be, percent of the public companies in this
only two years of implementation for they are surely far outweighed by these country.
accelerated filers, market participants more obvious cost figures. The Report One could cite any number of flaws
and regulators do not have sufficient states that the benefits are of less certain in this approach, but several in
information to make final decisions value and moves on to other matters. particular stand out:
regarding the long-term application of The Advisory Committee, by and • First, the entire premise of SOX was
these important internal control large, agrees that internal controls over to bolster investor confidence by
requirements for smaller public financial reporting at public companies requiring meaningful corporate
companies. I recommend that a process are important. More specifically, we governance and financial reporting
be developed to gather empirical, field- assert they are an important feature for reforms. Likewise, maintaining investor
driven information to resolve this accurate financial reporting, investor protections is a primary tenet of the
important question, and that an protection, and market integrity. But is Committee Charter. Properly designed
additional deferral be granted until this there a measurable benefit? It is and functioning internal controls over
can be accomplished. impossible to measure the value of a financial reporting were and are a
financial/accounting fraud avoided. In cornerstone of this legislation. Proper
Part VIII. Separate Statement of Mr. structuring and implementation of 404
2005, there were approximately 1300
Schacht restatements and weaknesses in requirements are very different from
This Separate Statement to the Final financial reporting revealed and fixed eliminating these completely for a broad
Report of The Advisory Committee on by a Section 404 inspired process, more segment of U.S. companies. That
Smaller Public Companies (the than double the number in 2004. This approach works against the statute’s
‘‘Report’’) is submitted for the purpose dramatic increase will have an legislative intent and the directive that
of dissenting on several of the primary inestimable and far-reaching impact on we heard from both Chairman
recommendations of the Advisory financial reporting reform. Some argue Donaldson and Chairman Cox.
Committee. These relate to the work of this is a reflection of deferred • Second, it is unclear to many
the sub-committee on Internal Controls maintenance on an internal controls whether the broad exempting
Over Financial Reporting (the ‘‘Sub- process that has been neglected and that recommendations of this subcommittee
Committee’’). As a member of the Sub- SOX represents a renaissance for proper are even within the commission’s legal
Committee and consistent with our internal control process and authority. Comprehensive, sweeping
dissenting opinion of December 14, environments. Whatever the reason, exemptions from Section 404 may not
2005, a copy of which is attached, we these are benefits that are significant be possible under the current
remain opposed to key portions of the and certain. Moreover, they are benefits legislation, which specifically excluded
Report. which, we believe, balance the cost of Section 404 from the Securities and
Observers and committee participants a properly scaled and verified internal Exchange Act of 1934. As the full
agree that the most substantive control structure. Commission works toward final
recommendations in the Report relate to recommendations, it would be well
Section 404 Exemption vs. Improved served to resolve that potential legal
the application of Section 404 of
Section 404 Implementation uncertainty so as to avoid further
Sarbanes-Oxley (‘‘Section 404’’) to
smaller public companies. As a The Sub-Committee set about its work litigation delays in addressing Section
Committee, we reviewed several issues with the focus of adjusting the main cost 404 concerns.
impacting smaller public companies. It driver of Section 404, the level to which • Third, with regard to MicroCaps as
is clear however, that the impacts of internal controls need to be defined, the Report recommends
Section 404, particularly the resource documented, verified and tested by exemptive relief from not only auditor
demands and costs of implementing management and outside auditors. The involvement in reviewing internal
404, have proven to be the most original objectives were to reduce the controls but also exempts the managers
challenging. During our deliberations, cost burdens but maintain the investor of these firms from having to do their
the Sub-Committee discussed dozens of protections associated with Section 404. own internal assessment of such
ways and options for reducing costs, The Sub-Committee focused on a variety controls. Essentially, no one has to
of ways to meet the objectives but check the design, implementation and
while maintaining investor protections.

narrowed its attention to two. The first effectiveness of internal controls over
Cost-Benefit Analysis is creating a more tailored and cost- financial reporting at these companies.
The Advisory Committee members efficient internal control structure and The reason for this complete 404
generally agree that the costs of verification process for small exemption according to the Report is
Sarbanes- Oxley (‘‘SOX’’) are the real companies, i.e., reducing the cost and that there is no specific directions/
guidance available to such small exemption, the Report suggests these economy are ill-served by a system that
company managers to know how to companies be reminded of pre-SOX neglects either.
create an appropriate internal control legal requirements to have an effective We heard commentary from several
structure. We wonder about two things system of internal controls in place. professional investors and institutional
in this context. First, how have these This legal reminder simply points out managers in support of Section 404
firms been able to meet the on going how ineffective the rules were pre-SOX requirements. The weight of such
legal requirements for maintaining an and how they are no substitute for testimony has been questioned since
effective system of internal controls having some level of external many do not invest directly in micro
(actually mentioned as part of the verification of controls as prescribed by cap firms. Moreover, the lack of specific
recommendation) and more Section 404. individual testimony from micro cap
importantly, if such guidance is missing and small cap investors along with the
for micro caps, how does it suddenly Better Implementation of Section 404 & observation that people still invest in
become clear for managers of small SOX ‘‘LIGHT’ these firms without Section 404
companies above $125 million in A more balanced approach to fixing protections, both in U.S. and foreign
market cap? In the event any of these the cost concerns of Section 404 is to markets, has been suggested as evidence
exemptive recommendations are continue requiring manager assertions that investors do not care about section
adopted by the SEC, we believe logic and auditor attestation of internal 404 protections.
dictates that managers in all public controls, but direct the appropriate While we encourage more of these
firms be required to complete an annual regulatory and de facto standard-setting small company investors to come
Section 404 assessment of internal bodies (the Committee of Sponsoring forward and participate in the next
controls. Organizations of the Treadway comment period, we believe the
• Fourth and maybe most important, Commission (COSO), the Public investor base involved in these firms is
small public companies need checks Company Accounting Oversight Board) very fragmented. These companies
and balances over financial reporting. and the SEC to develop specific represent somewhere between 70 and 80
This includes the Section 404 checks guidance for small companies. This percent of public companies and
and balances in our view. The Report approach has been referred to as a ‘‘404 collectively have millions of individual
indicates that: Small cap firms have less Light’’ or ‘‘SOX Light’’ approach. retail and private shareholders. It is
need for internal controls; requiring However, the term has become unlikely this group will magically
external verification of internal controls confusing over the course of the coalesce and speak with a collective
is a waste of corporate resources; and, Committee debate. voice on this or any other regulatory or
that better corporate governance is a financial reporting issue affecting the
Much of the outline for this approach
substitute for such verification. It companies in which they invest. That
appeared in preliminary
further suggests that investors in these silence should not be misinterpreted.
recommendations of the Sub-
companies don’t particularly care about These are precisely the investors that
Committee. We encourage the
internal control protections and that need the formal and self-regulatory
Committee to be clear on the options for
these companies represent an ‘‘system’’ to provide the necessary
better implementation and for the
inconsequential bottom 6% of total U.S. protections, transparency and honesty
Commission to consider a broad range
market capitalization, rendering even an that ensures a fair game. It is what
of approaches. These may include: (1)
Enron-like blowup a minor event. At the continues to make U.S. markets the gold
same time, the Report characterizes Reviewing/refining the existing AS–2
standard.
such small companies as a critical link standards; (2) possible development of We appreciate the opportunity to
in economic growth and an alternative auditing standard (the serve on the Advisory Committee and to
competitiveness and that Section 404 is Report references AS–X) that provides serve as a representative for investor
the regulatory tipping point and barrier for a meaningful, but more cost effective views. We encourage investors to
to accessing public markets. Parsing audit; and (3) development of specific provide timely commentary to this
through these contrasting views of directives from COSO and PCAOB on Report. As with any regulation, it is
inconsequential vs. critical seems to how to ‘‘right-size’’ for small issuers, the important to reach the proper balance
suggest incorrectly that venture capital control structure, the requirements for between cost burden on the issuer and
exit strategies are more important to managers assessment and the scope of investor protection. We firmly support
protect than public investors providing an internal controls audit. realignment and better implementation,
risk capital. A number of experts we This ‘‘Better Implementation’’ not elimination of Section 404, as the
heard from feel that properly structured approach appears in the Report, but proper balance.
and verified internal controls are comes only as a fall-back alternative to
probably more important for the riskier, the exemptive recommendations. To Statement of Mr. Schacht Dated
smaller firms and that additional ensure continued investor confidence in December 14, 2005
corporate governance provisions are in our markets, we support the approach I appreciate the opportunity to
no way a substitute for properly that preserves the investor protection address the entire committee on the
working internal controls. For example, aspects of 404 while lowering costs to work of the 404 subcommittee and want
these small firms consistently have implement and verify proper internal to acknowledge all of my colleagues’
more misstatements and restatements of controls over financial reporting. hard work. It was a pleasure working
financial information, nearly twice the Investors Support Section 404 with them.
rate of large firms, according to one As a committee, we have reviewed
report. Alarmingly, these small firms It is clear that we need to do several issues affecting smaller public
something for small companies. companies. It is clear however, that the
also make up the bulk of accounting

fraud cases under review by regulators Investors in these companies, more than impacts of Section 404 of Sarbanes-
and the courts (one study puts it at 75 anyone, have a significant stake in Oxley, particularly the implementation
percent of the cases from 1998–2003). making sure we balance the regulatory costs, have proven to be by far the most
• Finally, we note that as part of each burden with the need to grow and challenging. While I do not agree with
of the recommendations for Section 404 access capital markets. Investors and the several subcommittee
recommendations, Section 404 is one of governance and financial reporting giving them a pass on any verification
the key issues to focus on. Solutions to reforms. Properly designed and and oversight of internal controls will
its overly burdensome cost, particularly functioning internal controls over come back to haunt us.
on small issuers, are not simple. financial reporting were and are a The subcommittee’s
Notwithstanding that I am the lone cornerstone of this legislation. Proper recommendations will now attract a
dissenting vote on the subcommittee, I structuring and implementation of 404 fuller public debate on some very
do want to acknowledge that this group requirements are very different from important public policy issues. I would
has examined this topic closely. They eliminating these completely for a broad offer this challenge to investors and,
fully considered my concerns and those segment of U.S. companies. That indeed, all participants in the financial
of others who commented on the proper approach works against the statute’s reporting process to get involved in
ways to ‘‘fix’’ 404. We discussed dozens legislative intent and the directive that commenting on these recommendations.
of ways and options for reducing costs, we heard from both Chairman It is important to reach the proper
while maintaining investor protections. Donaldson and Chairman Cox. balance between cost and investor
We all agree that the costs of SOX are • Second, it is unclear to many protection. Realignment not elimination
the real issue. They have been too high, whether the broad exemptive of Section 404 is needed to accomplish
exceeding all estimates, and they hit recommendations of this subcommittee that.
small companies much more are even within the commission’s legal
significantly. There have been Part IX. Separate Statement of Mr.
authority. Comprehensive, sweeping
numerous cost studies and other Veihmeyer
exemptions from Section 404 may not
anecdotal comments on whether these be possible under the current Section 404 of Sarbanes-Oxley has
costs are or will be coming down in legislation, which specifically excluded contributed significantly to the
subsequent years. I think the evidence Section 404 from the Securities and improvement of financial reporting,
will only be clear once we have actual Exchange Act of 1934. As the full oversight of internal controls, and audit
data in the coming months, because this committee works toward final quality. The public interest and the
is clearly not yet at a point of recommendations, it would be well capital markets have been well served
equilibrium. For many companies that served to resolve that issue, as I expect by this legislation. At the same time,
have yet to go through the process, the there will be legal challenges of this compliance with the provisions of
initial costs will be high. There is no authority. Section 404 has placed important
question about this. • Finally, and maybe most responsibilities on issuers and auditors
Also, we all agree that internal importantly, small public companies that are both expensive and time
controls at public companies are need checks and balances over financial consuming. Clearly, the important goals
important. They are an important reporting. They consistently have more of Section 404 must be achieved in the
feature for accurate financial reporting, misstatements and restatements of most cost-effective and least
investor protection, and market financial information, nearly twice the burdensome manner, to ensure that the
integrity. Some argue that internal rate of large firms, according to one costs of Section 404 do not outweigh the
controls have been somewhat neglected, report. Alarmingly, they also make up benefits. This is particularly challenging
and SOX has tried to bring about some the bulk of accounting fraud cases under with respect to smaller public
assurance that adequate controls are in review by regulators and the courts (one companies. The Advisory Committee on
place and working as desired. How the study puts it at 75 percent of the cases Smaller Public Companies has worked
markets get that assurance—that is, the from 1998–2003). very hard to determine where to strike
level to which these internal controls A more balanced approach to fixing the appropriate balance between the
need to be verified and tested by SOX 404 is to continue requiring benefits to investors and the burdens on
management and outside auditors—is manager assertions and auditor issuers. The Final Report of the
the rub. attestation of internal controls, but Advisory Committee is the result of that
The subcommittee goal was to reduce direct the appropriate regulatory and work. While I respect the Committee’s
the cost burdens but maintain the defacto standard-setting bodies (the efforts to find the best possible solutions
investor protections associated with Committee of Sponsoring Organizations to these difficult problems, I differ with
Section 404. These need not be of the Treadway Commission (COSO), the majority over one fundamental
mutually exclusive. My concern, and the Public Company Accounting principle. In my judgment, sound public
the basis for my dissent, is that the Oversight Board) and the SEC to policy dictates that the protections
panel’s recommendations make them develop specific guidance for small provided by Section 404 should be
mutually exclusive. We seem to say you companies. These would specifically available to investors in all public
can’t have meaningful cost reductions outline appropriate control structures companies, regardless of size.
unless you eliminate 404, including the and the auditing scope for small Accordingly, our focus at this time
investor protections. companies under 404—a SOX ‘light’ should not be on exempting companies
Our biggest concern is that the main approach. from Section 404, but on developing
recommendations give a flat-out Much of the outline for this approach implementation guidance for assessing
exemption from all auditor 404 appears in Recommendation 3 of the and auditing internal control over
involvement in reviewing and subcommittee’s report. However, it financial reporting for smaller public
confirming internal controls. This is not comes only as a fall-back alternative to companies that recognizes the
for just a few, but for what will the exemptive recommendations. To characteristics and needs of those
effectively be more than 80 percent of ensure continued investor confidence in companies. This guidance should be
the public companies in this country. our markets, we deserve an approach jointly developed by regulators, issuers
One could cite any number of flaws that preserves the investor protection and the accounting profession and
in this approach, but three in particular aspects of 404 while lowering costs to should be field-tested for effectiveness,
stand out: implement and verify proper internal including appropriate cost analysis,
• First, the entire premise of SOX was controls over financial reporting. before implementation.
to bolster investor confidence by It is clear that we need to do The Final Report provides extensive
requiring meaningful corporate something for small companies. But root-cause analysis of the costs of
compliance with Section 404, but fails will result in users’ misunderstanding Standard No. 2. In addition, I believe
to address the reality that economies of the level of assurance provided by the that field testing the effectiveness of this
scale do influence the relative cost of auditor. It is important to note that a additional guidance, including
regulatory compliance and professional well-designed system of internal appropriate cost analyses, should be
services, including audits of financial control, while vital, does not equate to performed to facilitate well-informed
statements. Therefore, there is need for the generation of reliable financial decisions regarding the reasonable
additional steps to be taken to further information in the absence of effective application of the provisions of Section
improve the execution of Section 404 operation of internal control. 404 in a smaller public company
compliance relative to smaller Accordingly, I believe that environment. It may become evident, as
companies, as described below. Recommendation III.P.3 would serve to a result of field testing and meaningful
I also believe that PCAOB Auditing widen an already existing expectation cost analyses, that an audit of internal
Standard No. 2 is fundamentally sound gap with respect to audit services at a control over financial reporting may not
and scalable, and it is not prudent to time when emphasis should be directed be justified for certain very small public
consider amending the Standard at this toward reducing that gap. companies that evidence certain
time. The first year of integrating the I do not support Recommendations characteristics. For those smaller public
financial statement audit with the III.P.1 and III.P.2 based on my belief that companies, an exemption from the
requirements of Auditing Standard No. Section 404 of Sarbanes-Oxley has made provisions of Section 404 may be
2 was a difficult process due to a and will continue to make significant warranted, but such an exemption
number of environmental issues that contributions to improving financial should be considered only after careful
have been well-documented. Simply reporting, oversight of internal controls, analysis of the data derived from the
stated, the full integration of the and audit quality. In my judgment, field tests. In short, we simply do not
financial statement and internal control sound public policy dictates that the have sufficient implementation
audit did not occur in year one. protections derived from these guidance, experience, or information
However, my firm’s experience is that contributions should be available to available at this time to make a
the additional year of experience, investors in all public companies, permanent reduction in the protections
coupled with the May 2005 guidance regardless of size. provided by Section 404.
from the SEC and the PCAOB, and the I believe that compliance with the It is essential that the additional
efforts of issuers and auditors to provisions of Section 404 by issuers, implementation guidance, specifically
improve their respective approaches, and application of the principles of tailored to the application of internal
has resulted in further integration of the Auditing Standard No. 2 by auditors, control concepts in a smaller public
financial statement and internal control represent evolutionary skills that will company environment, be developed
audit and is reducing the total cost of become more effective and efficient and tested expeditiously, given the
compliance. I believe that issuers and with more experience. As noted above, importance of this issue to smaller
auditors should be allowed the the effectiveness and cost-efficiencies of public companies and investors. While
opportunity to introduce incremental Section 404 execution have improved this guidance is being developed and
effectiveness and efficiency into the over the first two years. However, field tested, I recommend the continued
compliance process—a migration that additional efficiencies and experience deferral of the Section 404 requirements
will occur naturally as issuers and with Auditing Standard No. 2 are not for all smaller public companies that
auditors move forward on the learning likely to fully address the concerns of have not already been required to
curve associated with reporting on certain-sized smaller public companies. implement Section 404. However, I
internal control over financial reporting. Accordingly, I recommend that would envision that such deferral
Because I believe that compliance regulators, issuers and the accounting would not extend more than a year
with the provisions of Section 404 profession work expeditiously to beyond the current implementation date
provides needed protection to investors develop specific guidance, focused on for non-accelerated filers.
in all public companies, regardless of the characteristics of these smaller It should be noted that this separate
size, I do not support recommendations companies and their internal control statement focuses solely on the
III.P.1, III.P.2, and III.P.3 in the Final structures, which will further improve recommendations to which I dissent,
Report, as each would serve to dilute the execution of Section 404 and not to any specific statements or
this protection. compliance. I will commit resources of opinions contained in the Final Report
Specifically, Recommendation III.P.3 my firm to participate in and support which are inconsistent with my own
referencing a standard providing for an this effort. Additional implementation views.
audit of the design and implementation guidance specifically tailored to the The work of the Advisory Committee
of internal control, but not the testing by application of internal control concepts and our Final Report has raised
the auditor of the operating in a smaller company environment important issues relative to application
effectiveness, is in my view not should, at a minimum, address the of the provisions of Section 404. To
advisable. While clear disclosure that a following: significance of monitoring address those issues, I propose
company has not undergone an audit of controls, risk of management override, additional guidance for smaller public
internal control over financial reporting lack of segregation of duties, extent and companies, and the field testing of that
is understandable to users, those same formality of company documentation guidance, relative to reporting on
users cannot be expected to assess the and assessment, and evaluation of the internal control over financial reporting
relative gradations of assurance competency of a smaller company’s as well as the continued deferral for
provided by this proposed distinction in accounting and financial reporting non-accelerated filers for an additional
reporting on internal control. An function. This guidance should address year if these activities cannot be
alternative providing for an auditor’s both the assessment to be made by completed within one year. I believe
report only on design and management and the auditor’s these proposals are consistent with our
implementation of internal controls, at a performance requirements relevant to Charter to further the SEC’s investor
time when much attention has been such assessment, as well as the protection mandate, and to consider
directed toward reporting on the execution of auditing procedures whether the costs imposed by the
effective operation of internal controls, pursuant to the provisions of Auditing current regulatory system for small
companies are proportionate to the G. Request for Public Comments on Authority: In accordance with Section
benefits, to identify methods of Committee Agenda 10(a) of the Federal Advisory Committee Act,
minimizing costs and maximizing H. Request for Public Input 5 U.S.C. App. 1, § 10(a), Gerald J. Laporte,
benefits, and to facilitate capital I. Background Statistics for All Public Designated Federal Officer of the Committee,
formation by smaller companies. Companies has approved publication of this release at
J. Universe of Publicly Traded Equity the request of the Committee. The action
Appendices* Securities and Their Governance being taken through the publication of this
Index of Appendices K. List of Witnesses release is being taken solely by the
L. Letter from Committee Co-Chairs to SEC Committee and not by the Commission. The
A. Official Notice of Establishment of Chairman Christopher Cox dated August Commission is merely providing its facilities
Committee 18, 2005 to assist the Committee in taking this action.
B. Committee Charter
M. SEC Statement of Policy on Accounting Dated: February 28, 2006.
C. Committee Agenda
D. SEC Press Release Announcing Intent to Provisions of Foreign Corrupt Practices Act
Nancy M. Morris,
Establish Committee *Access to each appendix is available by
clicking its name on the copy of this page Committee Management Officer.
E. SEC Press Release Announcing Full
Membership of Committee posted on the Internet at www.sec.gov/info/ [FR Doc. 06–1992 Filed 3–2–06; 8:45 am]
F. Committee By-Laws smallbus/acscp-finalreport_ed.pdf BILLING CODE 8010–01–U

Notice: Meetings: Securities and Regulatory Issues For Smaller Companies Smaller Public Companies Advisory Committee Final Report

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Notice: Meetings: Securities and Regulatory Issues For Smaller Companies Smaller Public Companies Advisory Committee Final Report

Uploaded by

Copyright:

Available Formats

Friday,

E. David Coolidge III, Vice Chairman,

approximately $787 million and less, which

We recognize that formal legal definitions of these 2002).

Microcap Companies ....................................................................................................... $128.2 1 52.6

internal controls (Recommendation independence rules (Recommendation

measure in determining which shares held by affiliates, calculation of public float

categories. 40 15 U.S.C. 77c(b).

www.aei.org/publications/pubID.23310/ COSO reconsider whether there is additional, more

Section 404 and non-accelerated filers that have not

employees, however, can usually parcel out their

IPO candidate elected to go public on the AIM

Financial Reporting Performed in Conjunction with

Obstacles Hinder Start-ups, Wall St. J., Jan. 25,

is any equity security that is not listed or traded on

129 Press Release, NASD, NASD Announces SEC

communication which, though not purporting to if particular contact is impermissible,

offering reforms. broker-dealers as persons who ‘‘effect any

159 Section 13(a) of the Exchange Act requires

15c2–11 Information on Non-NASDAQ Securities). Community Bankers, to Committee (Aug. 9, 2005),

thereof, for publishing a quotation, acting as review process, in which a company

agenda to provide guidance regarding the

while maintaining investor protections.

also make up the bulk of accounting

You might also like