By James Hamilton, J.D., LL.M.
The bi-partisan Garrett-Adler Amendment exempting smaller reporting companies from the internal control auditor attestation requirements contained in Section 404(b) of the Sarbanes-Oxley Act has been criticized by an SEC Commissioner even while it appears to have White House and Treasury support. The amendment is part of the Investor Protection Act that recently passed the House Financial Services Committee. The amendment’s language mirrors legislation Rep. Garrett introduced earlier this year, the Small Business SOX Compliance Relief Act, HR 3775.
Section 404(a) of Sarbanes-Oxley requires that annual reports filed with the SEC must be accompanied by a statement that company management is responsible for creating and maintaining adequate internal controls and a further statement assessing the effectiveness of those controls. Section 404(b) requires the company's outside auditor to report on and attest to management's assessment of the company's internal controls.
Specifically, the Garrett-Adler Amendment would permanently exempt non-accelerated issuers with a market capitalization of $75 million or less from Section 404 (b) of Sarbanes Oxley Act. It only exempts small companies from complying with this one particular subsection of Sarbanes Oxley, while maintaining investor protections by requiring them to continue complying with the rest of the statute. In addition, it requires the SEC and the Comptroller General to conduct a study to determine how the SEC can reduce the burden of complying with Section 404(b) for companies whose market capitalization is between $75 and $250 million. The study must also consider whether reducing the compliance burden or a complete exemption for these companies would encourage them to list on US exchanges in their initial public offerings.
Although the stated intent of Sarbanes-Oxley was to provide investor confidence in the financial markets through greater accountability and disclosure, some members of Congress believe that the Act has had the unintended effect of creating undue and often unbearable burdens on small businesses. According to Rep. Garrett, there is a place for federal oversight, but the weighty cost of compliance under Section 404 is slowly strangling small businesses. It is diverting valuable resources away from other legitimate business needs; creating massive and tedious documentation requirements; and discouraging the public listing of both international and domestic companies on U.S. markets.
The SEC has repeatedly extended the deadline for non-accelerated filers to begin providing audited assessments of their internal controls over financial reporting, an acknowledgement of continued concern about compliance costs. Although reforms were made in 2007 to relax the guidelines for smaller companies, noted Rep. Garrett, businesses of all sizes still report excessive compliance costs. He cited an SEC report from September 2009 that found a majority felt that the costs of compliance outweighed the benefits. This was especially true among smaller companies.
Rep. Adler said that the current small business exemption will expire early next year unless Congress makes it permanent. He emphasized that the amendment will provide stability and predictability for these businesses by permanently exempting them from these costly regulations. In his view, the "one size fits all" regulatory approach to implementing section 404 of Sarbanes Oxley has had a disproportionately negative impact on small and medium sized companies. The current and pending compliance burden has sent many companies to market overseas or dissuaded them from going public on US exchanges. This is one reason, said Rep. Adler, that the White House and Treasury support the amendment.
The broad goal of the amendment is to maintain the high levels of transparency individual investors need to make informed decisions, without damaging market competiveness. These regulations should take into account the different characteristics and limitations of various sized companies, said Rep. Adler, keeping the largest companies in check, while allowing smaller companies to help the economy grow and create jobs.
In remarks during the markup of the legislation, Ranking Member Spencer Bachus echoed the need for these non-accelerated filers to have predictability going forward. He also supports having the SEC study the impact of 404(b) on companies with a market cap between $75 million and $250 million. But the Ranking Member cautioned that Congress must be watchful for possible compliance problems when companies granted the $75 million exemption transition above that amount.
There is growing opposition to the amendment from the SEC, some House leaders and the auditing industry. During the markup, Rep. Paul Kanjorski, Chair of the Capital Markets subcommittee, said that making the 404(b) exemption permanent thwarts the intent of Sarbanes-Oxley and could even be dangerous. He said that Congress intended for all companies to comply with the auditor attestation provisions of section 404; and now, without evidence, the amendment reverses congressional intent. He added that the SEC Chair opposes the amendment.
In recent remarks opposing the amendment, SEC Commissioner Luis Aquilar said that, while the Commission does not generally track companies based on market cap, the SEC does have data on companies that generally have $75 million or less in public float, and the staff estimates that over 6,000 public companies may fall under that threshold. To repeal this part of Sarbanes-Oxley now, he cautioned, would be to throw away a substantial amount of work done by regulators, companies, and private organizations to make compliance with 404(b) more cost-effective.
During the period when the SEC suspended 404(b) for smaller public company compliance, the SEC and PCAOB developed standards, rules and guidance to allow 404(b) to be implemented in a manner that would work for both large and small public companies. A central goal of this work focused on making sure that costs for smaller public companies were not overly burdensome. It would be ironic that, if 404(b) is undercut now, the benefit of all the work done by the SEC and PCAOB will never be realized and smaller public companies would not be able to take advantage of the practical lessons learned from companies that are already complying. He urged the House to strip out the Garrett-Adler Amendment and also urged the Senate not to include what he called ``this deregulatory initiative’’ in its parallel legislation.
Similarly, in a letter to the Committee leadership, the Center for Audit Quality said that it supports the SEC’s position that there be no further delay in Section 404(b) compliance for smaller companies. Further, CAQ believes that the required independent audit of management’s assessment of the effectiveness of a company’s internal controls, as required by section 404(b), has been integral to the achievement of the intended objectives of internal control reporting under Section 404.
Echoing Commission Aquilar, CAQ noted that the SEC and PCAOB initiatives have significantly reduced the cost of complying with the external audit of internal controls required by 404(b). CAQ particularly extolled the PCAOB’s adoption of Auditing Standard No. 5, which enables auditors to focus their effort on those areas that were critical to a company’s internal controls, use their judgment, and scale the procedures necessary to conduct the audit to a company’s particular circumstances.