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A 'kinder, gentler' Section 404?

You can’t tell the players without a scorecard? When it comes to regulation of smaller public companies, you can’t even understand the scorecard.

This article traces recent intense activity concerning Section 404 of Sarbanes-Oxley, and discusses other significant SEC suggestions in related areas.

404 History

Section 404 requires public companies to report annually on internal financial controls, and for their CPAs to comment on that report. The procedure, far more expensive than anticipated, has been consistently criticized by the business community.

The SEC a number of times has extended the Section 404 compliance deadline for companies with less than $75 million of public float – most recently until fiscal years ending after September 2007.

Whether smaller companies should be exempted or whether 404 standards should be softened is subject to debate. Section 404 compliance is controlled partially by COSO (a board including accountants, businessmen and representatives of the American Institute of Certified Public Accountants).

In the January 2006 SEC Watch column, I reviewed COSO proposals, promulgated for public comment in October 2005. Although the formal public comments were not made available, many observers agreed that the COSO proposals contained few useful suggestions for reducing 404 costs for smaller companies.

Criticism of COSO proposals was echoed by SEC representatives and, on Dec.14, 2005, the 404 Subcommittee of the SEC’s Advisory Committee on Smaller Public Companies published a preliminary report recommending exemptions from 404 for smaller companies.

On April 13, the U.S. Government Accountability Office issued a report to the U.S. Senate, analyzing the impact of 404. Based upon extensive research, the GAO stated that Section 404 did not appear to have made it more difficult to raise capital. It also indicated that although SOX has perhaps depressed initial public offerings, it is likely that market performance and listing standards played a role.

The Advisory Committee’s December report did not contain recommendations that would be helpful to smaller companies.

Undaunted, on April 23, the SEC’s Advisory Committee formally issued proposals softening the 404 scheme for smaller companies.

The committee seemed to be looking at a different America from that depicted by the GAO, an America where 404 did make it more difficult to raise capital, causing companies to “go dark” (falling below stock ownership levels that trigger SEC reporting) or to flee to European stock markets. The committee indicated that IPOs were clearly depressed by Section 404. It suggested that smaller companies must be dynamic and flexible, and such flexibility does not allow standardization of internal controls anticipated by 404.

Until a better framework for 404 compliance could be generated (a swipe at the October 2005 COSO recommendations), the committee indicated that microcap companies with less than $125 million in market cap and annual revenues would be exempt from 404 compliance (although such companies would still establish internal controls, disclose material weaknesses, and acknowledge management responsibility in CEO and CFO certifications), and companies with less than $250 million in annual sales and less than $787 million in market cap must comply at the company level, but would be exempted from 404(b), which requires auditor review.

Also, according to the committee, it is appropriate “to determine the necessary structure for COSO to strengthen it in light of its role” by including a broader member constituency.

SEC Action

It took the SEC all of 24 days to scuttle the Advisory Committee’s 404 recommendations.

On May 17, the SEC rejected all exemptions for small companies. According to The Washington Post, the SEC “bucked intense, months-long lobbying by business groups” and instead of promising exemptions it proposed:

  • A new SEC concept release and regulations concerning 404 implementation;
  • An extended deadline for compliance by “smallest companies” for only a few months;
  • SEC review of COSO’s forthcoming guidance to “consider the extent to which the additional guidance that COSO provides is useful to smaller public companies;”
  • Establishing new guidance to management “in it’s performance of a top-down, risk-based assessment of internal control over financial reporting, including compliance steps “scalable” for smaller companies; and
  • that PCAOB, the SOX-created governmental board overseeing SEC accounting, modify its Accounting Standard No. 2 to guide accountants in reviewing 404 compliance.

    The SEC will evaluate whether PCAOB has encouraged implementation of PCAOB’s May 2005 statement urging accountants to be more flexible in approaching 404 compliance.

    All filers would be required to comply with the provision of management assessments required by 404(a) for fiscal years beginning on or after Dec. 16.

    On the same date as the SEC press release (May 17), the PCAOB announced a four-point plan to improve auditor implementation (PCAOB pronouncements affect the auditors, not company efforts).

    PCAOB promised to:

  • Amend AS No. 2 to assist auditor efficiency, clarify definitions, integrate audits of financial statements and internal controls, clarify materiality standards and allow auditors to rely upon work of others;
  • Reinforce auditor efficiencies in its inspections (the SEC will itself review PCAOB’s performance in this area);
  • Develop implementation guidance for auditors of smaller companies; and
  • Continue forums on auditing small business.

    Legislative front

    Also on May 17, in reaction to the SEC’s refusal to exempt smaller companies, bills were introduced in Congress to amend 404.

    The “COMPETE Act” would exempt entirely from 404 any company that: (i) has market cap below $700 million; or (ii) has product revenue below $125 million; or (iii) has less than 1,500 record beneficial holders; or (iv) does not file 1934 Act reports or has done so for less than one year.

    Other sections invite SEC supervision of auditors, clarify that a 404 “weakness” must exceed a de minimus impact of 5 percent of net profits, and require rules to permit auditors to provide greater guidance to companies.

    This legislation faces a perilous future given the SEC’s position and the outcry from investor groups against 404 exemptions, particularly since it would extend exemptions to many companies already complying with 404.

    Presently, it appears the anticipated SEC exemptions from 404 compliance by small companies will not happen. Smaller companies, lagging in compliance efforts, and smaller companies already compliant with 404 but hoping for exemption, must accept that 404 is here to stay for all public enterprises, absent legislation from Congress.

    Other important initiatives

    The SEC Advisory Committee report addressed more than 404.

    The SEC’s May 17press release is silent with respect to “other issues affecting smaller companies.” The Commission simply expresses appreciation for significant effort.

    Lost in the 404 furor are revolutionary proposals to assist small companies in capital formation. These recommendations are premised upon SEC findings of the deleterious effect on capital formation which the Advisory Committee blames on SOX, reflecting a view of our economy not wholly shared by the GAO.

    In light of disagreement about basic facts, it is difficult to speculate as to the future of these proposals.

    The Advisory Committee made the following proposals:

  • Eliminate small business reporting thus ending its marketplace “stigma”. The committee suggests building small business reporting into regulation SK forms, and (for issuers with less than $787 million of market cap) reducing requirements concerning business description, financial data, certain tables and the like.
  • Allow all NASDAQ and over-the-counter bulletin board companies to utilize Form S3 (an abbreviated form for issuing new securities) if subject to 1934 Act reporting for at least one year even if these companies were not timely in filings, and permit using Form S3 for secondary offerings.
  • Adopt policies encouraging dissemination of research on smaller public companies so as to increase liquidity, allowing company-sponsored research to be circulated if so labeled.
  • Establish a new federal and state private offering exemption allowing advertising and general solicitation, provided the actual purchasers are wealthy, sophisticated, involved in the issuer, or institutions.
  • Adopt the American Bar Association’s recommendation for streamlined NASD registration of finders and business brokers (who often assist smaller companies).
  • Change the 1934 Act rules, which allow companies to discontinue periodic reports if record securities holders fall below 300, by piercing record ownership (particularly ownership in “street name”) and counting the number of beneficial shareholders.
  • Bar NASD broker dealers from making trades in securities for non-reporting companies unless they gather certain information pursuant to 1934 Act Rule 15(c) 2-11. This information, presently filed only with the NASD, would be filed with the SEC to increase smaller company liquidity.
  • Increase availability of SEC Rule 701, which exempts from registration requirements certain offerings of securities pursuant to option, restricted stock and other compensation plans.
  • Allow all proxy materials to be posted on the Internet (eliminating the current requirement that stockholders affirmatively elect electronic delivery), reducing the cost of maintaining public status.
  • Shorten the “integration safe harbor” in Regulation D private placements to 30 days (allowing small companies to continuously raise money).
  • Require the SEC to issue regulations for SOX Section 402 (which prohibits loans by public companies to principal executives), permitting cashless option exercises, advancements of payments for indemnification from litigation expense, relocation loans and split dollar insurance if approved by independent directors.
  • Establish an SEC help desk and written guidelines addressing smaller companies.


    Unless Congress acts, the battle for 404 exemption is over. 404 will apply in a kinder, gentler environment monitored by the SEC, assuring that COSO and PCAOB do not forget that “simpler” and “cheaper” is better for smaller companies.

    Recommended reforms beyond 404 are unclear, but could represent a significant loosening of current practice.

    Reforms reflect an underlying policy: If there is information available pursuant to the 1934 Act, then a company should have few limitations on issuing additional shares. This was the SEC’s approach in its 2005 amendments allowing larger companies greater latitude.

    The Advisory Committee wants to capture some of that flexibility for its own constituency, a constituency in need of flexibility if small business is to remain an engine for economic growth in the U.S.

    Stephen M. Honig is a member of Duane Morris’ corporate department in the firm’s Boston office. You can reach him at smhonig@duanemorris.com.

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