By James Hamilton, J.D., LL.M.
The recently released Bloomberg-Schumer report is a very wide-ranging and well written document that includes specific recommendations designed to make the US capital markets more competitive. While the report confirms the advantages of deep, liquid, transparent markets supported by strong investor protection, it also posits that it is critical to implement changes designed to make US financial markets more competitive. The report was commissioned by NYC Mayor Michael Bloomberg and Senator Charles Schumer.
There is much to ponder in the report, but I want to focus on specific recommendations directed at the SEC and PCAOB. The report finds it imperative that the SEC and the PCAOB adopt their proposed revisions to the guidelines controlling the implementation of the internal control mandates of sec. 404 of the Sarbanes-Oxley Act. The report wants these proposals to ensure that the audit of internal controls takes a top-down perspective, is risk-based, and is focused on the most critical issues. The guidance should also enable auditors and management to exercise more judgment and emphasize materiality.
Critical to achieving this goal is the correct revision of the definition of material weakness. In the report’s view, the PCAOB’s proposal to shift the standard for material weakness from one of “more than remote” likelihood to one of “reasonable possibility,” still leaves significant room for interpretive uncertainty. In the highly visible and litigious environment in which audit firms operate, reasoned the report, such uncertainty is likely to lead to costly risk-averse behavior, undermining the benefits of the regulators’ adoption of a risk-based standard. Therefore, to the extent that there is still room to provide additional practical guidance with regard to the definition of “materiality,” the SEC and PCAOB should, after analyzing the comments, provide such further direction.
With regard to the SEC and PCAOB proposals for small company compliance with the internal control mandates, only time will tell if the proposed flexible approach will sufficiently alleviate the burden of 404-related compliance on smaller companies. The report suggested that the SEC and PCAOB continue to monitor the situation and, if compliance costs for smaller public companies fail to come down sufficiently, they should consider additional means of addressing these companies’ needs. One possible avenue for relief would be to give smaller companies the possibility of opting out of the more onerous provisions of Sarbanes-Oxley, provided that they prominently disclose that choice to investors.
According to the report, this alternative would have the virtue of effectively providing smaller companies and their investors with the ability to determine whether the lower cost of capital stemming from incremental investor confidence, which is itself tied to the safeguards of Sarbanes-Oxley, outweighs the associated compliance costs.