Wednesday, August 07, 2019

Groups weigh in on proposal to exempt smaller companies from auditor attestation requirement

By Amanda Maine, J.D.

The comment period for the SEC’s proposal to amend its definitions of large accelerated filer and accelerated filer closed last week with dozens of interested parties opining on the proposed change that would exempt many small companies from the Sarbanes-Oxley Act’s auditor attestation requirement of Section 404(b). Industry groups and biotech companies applauded the SEC’s proposal as reducing burdensome costs for small businesses, while investor and consumer advocates voiced concern that weakening the current rules would weaken internal controls and result in more fraud.

Proposal. In May, the SEC proposed amendments to Exchange Act Rule 12b-2 that would revise the “accelerated filer” and “large accelerated filer” definitions. As a result of the proposed amendments, smaller reporting companies with less than $100 million in revenues would not be required to obtain an attestation of their internal control over financial reporting (ICFR) from an independent outside auditor, although these companies would still be required to establish, maintain, and assess the effectiveness of their ICFR. The proposal is intended to relieve smaller companies from the expenses associated with obtaining an auditor attestation on ICFR. The Commission voted to propose the amendments by a 3 to 1 vote. Dissenting, Commissioner Jackson stated that the alleged costs of auditor attestation cited in the proposal had no basis in evidence.

Industry groups. Chamber of Commerce’s Center for Capital Markets Competitiveness (CCMC) applauded the SEC’s goal of promoting capital formation for smaller issuers, particularly in light of the decline of public companies in recent years. CCMC reiterated in its letter its support for making the ICFR requirement scalable and praised the SEC for proposing a revenue-only test and not using a public float test, which would still require some pre- or low-revenue companies that may be highly valued to be subject to the auditor attestation requirement despite their lack of revenues.

The National Association of Manufacturers (NAM) called on the SEC to fully align the non-accelerated filer definition with the smaller reporting company (SRC) definition, rather than limiting the scope of the proposed rule just to a subset of SRCs. This would provide regulatory certainty to small businesses sand reduce the burden on all SRCs, NAM stated. The SEC should engage in regulatory consistency, the letter urged, noting that under the proposed rule, some SRCs would qualify as non-accelerated filers (and thus be exempt from SOX 404(b)), and some would not. “Uniformity in and of itself is a compelling justification to align the two definitions,” according to NAM.

The Independent Community Bankers of America (ICBA) also voiced its support for the proposed amendments. According to ICBA, the new $100 million revenue threshold would have a significant positive impact on publicly held community banks and bank holding companies that are SEC filers, since most of these institutions qualify as SRCs and have annual revenues of less than $100 million. ICBA stated that permitting these issuers to avoid the burdens of an accelerated or large accelerated filer will enhance their ability to preserve capital without significantly affecting the ability of investors to make informed investment decisions based on the financial reporting of those issuers.

However, ICBA added that it believes that the proposed amendments do not go far enough for community banking institutions. These institutions are already subject to banking regulation and supervision, and their internal controls are evaluated regularly as part of their safety and soundness exams. Instead, ICBA supports legislation (S. 1233) that would exempt any SEC-registered community bank and bank holding company with assets less $5 billion from the Sarbanes-Oxley 404(b) auditor attestation requirement.

Investor groups. Investor advocacy groups were more skeptical about the proposed amendments, with several groups recommending against the Commission finalizing the proposal. The Council of Institutional Investors (CII) advised that exempting low-revenue issuers from the auditor attestation requirement would substantially impact the quality of those issuers’ financial statements. In fact, CII asserted that low-revenue issuers actually benefit more from the requirement than investors in other issuers, observing that, according to its research, the likelihood of fraud is most pronounced in high-growth companies with large price-to-revenue ratios, which encompasses the kinds of companies the proposal would exempt.

CII also agreed with Commissioner Jackson that the SEC’s economic analysis does not provide an adequate basis for the proposal. It cited another comment letter on the proposal submitted by several university professors detailing alleged problems with the SEC’s analysis, including considering the costs but not quantifying the evidence of ICFR audits; focusing on the rate of restatements rather than the magnitude of restatements; and failing to consider the historic rate of fraud within the set of affected companies.

The Consumer Federation of America (CFA) expressed similar concerns in its letter. According to CFA, the proposal would roll back the Sarbanes-Oxley Act’s reforms for several hundred large but low-revenue public companies without providing any “credible support” for the claim that doing so would promote capital formation. Despite the proposing release’s assertion that it would help small companies, CFA observed that smaller companies (non-accelerated filers), as well as all but the very largest newer public companies (emerging growth companies), are already exempt from the ICFR auditor attestation requirement.

CFA also questioned the proposal’s contention that the proposed amendments would have a material impact on companies’ decisions regarding whether to go public. Like Commissioner Jackson, CFA took issue with the data used in the Commission’s analysis. “The release fails to make clear what percentage of the reported decline in [IPOs] occurred in the years immediately before SOX was adopted and implemented—a percentage that is likely quite substantial given that the period in question included both the bursting of the tech stock bubble and the wave of accounting scandals that led to the passage of SOX,” CFA advised.

According to the comment letter submitted by Better Markets, the SEC’s proposal would (1) decrease the quality of financial reporting; (2) weaken internal controls; (3) increase the number of accounting misstatements and restatements; (4) increase the opportunity for struggling companies and executives to commit fraud; (5) reduce the ability of regulators to detect and deter fraud; (6) restrict investors from protecting themselves by removing an important source of information; (7) diminish market integrity; and (8) harm investor confidence.

Better Markets stated that, according to studies, including studies by the SEC itself, over 40 percent of non-accelerated companies not subject to the auditor attestation requirement have ineffective ICFR, compared to less than 9 percent and 5 percent of accelerated and large accelerated filer companies, respectively. Exempting these companies from independent attestation “would allow executives—particularly those at companies facing financial challenges—to either not establish effective ICFRs…or permit the under-reporting or misreporting of ineffective ICFRSs to go undetected,” Better Markets warned.

Accounting firms. The major accounting firms also weighed in on the proposal, with some expressing cautious or reluctant approval while others opposing the amendments. PricewaterhouseCoopers noted that the proposal may potentially have a detrimental impact on the quality of financial reporting for the affected registrants, but added that audits performed under PCAOB standards require an auditor to obtain a sufficient understanding of each component of ICFR, including identifying the types of potential misstatements; assessing the factors that affect the risks of material misstatement; and designing further audit procedures, regardless of whether the issuer is subject to the SOX auditor attestation requirement.

Deloitte & Touche praised Sarbanes-Oxley’s auditor attestation requirement as contributing to the overall enhanced reliability of audited financial statements and more effective corporate governance practices. Due to these benefits of the auditor attestation requirement, Deloitte stated that it does not believe that “it would be prudent to roll back existing requirements for a large population of issuers that are currently complying with Section 404(b).” However, if the SEC does adopt the amendments, it should support efforts to ensure that the requirements of both Section 404(a) and (b) are clear and scalable for companies of varying size and complexity.

Ernst & Young expressed concern that while the low-revenue issuers the proposal is intended to help may have less complex accounting systems and processes, these issuers may also have fewer (and sometimes less experienced) employees performing and monitoring internal control functions. EY encouraged the SEC to emphasize in its adopting release that audit committee of issuers that are exempt from Section 404(b) can determine whether voluntarily obtaining an independent audit of ICFR is appropriate.

KPMG stated that in generally supports the proposal and does not think that the proposed changes do not add complexity to the current regime. The firm expressed its opposition to changes to the frequency of ICFR audits for companies subject to the provisions of SOX 404(b). According to KPMG, auditors will continue to test ICFR even if not required because of automation. If annual frequency changed to three years, there would not be a decrease in costs, but investors would not have the benefit of the annual audit report. KPMG also advised that a lot can change in a three-year period and changing the frequency would not promote effective ICFR. KPMG also recommend that the Commission retain current disclosure requirements when a registrant voluntarily provides an ICFR audit.

BDO stated that it does not support amending the accelerated filer definition. BDO acknowledged that lower-revenue issuers may be less susceptible to the risk of certain kinds of misstatements (such as revenues); however, less management attention to internal controls may result in a higher risk of misstatements in other accounting areas. These include early-stage companies that enter into complex transactions and arrangements and the accounting for clinical trial costs, BDO explained. If the proposed amendments are adopted, BDO requested that the Commission issue interpretive guidance and provide ample notice of the compliance date.

Biotech companies. New biotechnology companies have been cited as potential beneficiaries of the proposed changes, and several biotech companies and industry advocates wrote to the SEC urging approval of the changes. According to the Biotechnology Innovation Organization (BIO), the amendments will lead to significant cost-savings for biotechs engaged in groundbreaking research at a time when their access to capital is most important. BIO advised that emerging biotech companies are unique compared to other industries in that they may operate for 10 to 15 years before generating product revenue and remain unprofitable during this period as resources are largely poured into R&D. Emerging biotech businesses rarely have the revenue to support the expense of complying with the auditor attestation requirement. According to BIO, investors want to know about the company's science, the diseases it is treating, the patient population, and the FDA approval pathway. Section 404(b) compliance does not address what investors are most concerned about, and only serves to divert funds from the company's progress in bringing their product candidates to market, BIO explained.

BIO’s views were echoed by several biotech and biopharmaceutical companies who also urged the SEC to approve the proposed amendments, as well as industry groups including the Council of State Bioscience Associations and the Advanced Medical Technology Association.