Wednesday, November 4, 2009

Sarbanes-Oxley Exemption Passes Congressional Committee

Earlier today, the House Financial Services Committee approved an amendment that would exempt small public companies from the provisions of Sarbanes-Oxley Section 404b. The Garrett/Adler amendment, offered by Rep. Scott Garrett (R-NJ) and Rep. John Adler (D-NJ), was approved in the HFS Committee today by a vote of 37-32, as part of the Investor Protection Act (IPA). The Committee voted in turn, by a vote of 41-28, to approve the IPA. (See: Financial Services Committee Approves Investor Protection Act. )

As noted in Adler's Nov. 3 press release, the Garrett/Adler amendment would not only exempt small businesses (with less than $75 million market cap), but would require the SEC, together with the GAO, to conduct a study directed at reducing the burden of Sarbox 404b on companies with market cap between $75 million and $250 million. Additionally, the amendment calls for the study to "consider whether reducing the compliance burden or a complete exemption for these companies will encourage them to list on exchanges in the United States in their initial public offerings."

The ultimate impact of the Garrett/Adler amendment will depend on whether it remains in the IPA when voted on by the full House of Representatives, and whether it will be included in the Senate’s version of the bill and ultimately signed into law.

Sarbanes-Oxley Section 404a requires a management report on internal control. Companies of all sizes currently provide the management report on internal control. Sarbanes-Oxley Section 404b, the target of the Garrett/Adler amendment, requires an external audit of internal control. Small public companies (non-accelerated filers, generally defined by the SEC as companies with less than $75 million market cap) have not yet been subject to the Sarbox 404b requirement. As described in SEC's Oct. 2 press release issued concurrently with SEC's Sarbox cost-benefit study, the SEC granted a final deferral of the effective date of Sarbox 404b for small companies, extending the deadline to annual reports for fiscal years ending on or after June 15, 2010. See related Final Rule.

Rationale Behind The Garrett/Adler Amendment
Garrett's Oct. 28 press release explained:
Although reforms were made in 2007 to relax the guidelines for smaller companies, businesses of all sizes still report excessive compliance costs, as noted in an SEC report from September 2009. In summarizing survey responses from businesses regarding the benefits of Section 404 compliance, the SEC wrote, “[A] majority felt that the costs of compliance outweighed the benefits. This was especially true among smaller companies.
Garrett's initial proposal, cosponsored with Rep. Carolyn Maloney (D-NY) was withdrawn, as was an earlier version of Adler's amendment. According to a report in today's WSJ, Small Business Gets Break in House Financial Overhaul Bill, by Kara Scannell and Damien Paletta:

[White House Chief of Staff Rahm] Emanuel negotiated with Mr. Adler to avoid a more damaging amendment that would have exempted firms already covered by Sarbanes-Oxley, those with market caps of less than $700 million, [House Financial Services Committee Chair Barney] Frank told reporters....

"It's odd that I should be defending the White House," Mr. Garrett said. Mr. Adler said he spoke with White House Chief of Staff Rahm Emanuel three times recently about giving small businesses relief.

House Financial Services Chairman Barney Frank (D., Mass.) and Rep. Paul Kanjorski (D., Pa.) both oppose the amendment, as do left-leaning consumer-advocacy groups.
SEC Chairman Mary L. Schapiro reportedly filed a letter with the House Financial Services Committee on October 16, indicating that she “opposes an exemption,” as reported by Zachary A. Goldfarb in today's Washington Post, Small Public Companies Win Exemption from Audits. However, it is not clear if Schapiro's views changed in light of modifications made over the past week to the earlier versions of the amendments; WSJ's Scannell and Damien reported today that: "SEC Chairman Mary Schapiro said earlier this week that she didn't oppose a move, but 'I don't want to just pass the problems around the map." In related news, see also Frank Seeks House Vote in December on Financial Measures, by Michael R. Crittenden of the WSJ.

My two cents
I remind you of the disclaimer that appears in the right margin of this blog, above the blogroll. I am not going to comment on the exemption provision in the Garrett/Adler amendment, only on the provision calling for GAO and the SEC to perform a cost study. Some may question why a new cost study on Sarbox is required, when the SEC just released its cost-benefit study in September (SEC study).

Cent one: I would submit that the cost-benefit study called for under the Garrett/Adler amendment may add some valuable information. For example, there could be benefits from adding an independent party (GAO) as co-head of a cost study on Sarbox, as compared to the SEC's study published in October, in which the SEC alone studied the cost-benefit of implementation of its own rules, and those of the PCAOB (which the SEC, in turn, is responsible for approving.)

One could contrast this with the decision of Congress last year, in the Emergency Economic Stabilization Act, to call upon solely the SEC (and not GAO) to conduct a study of the impact of the fair value accounting rules, given that the SEC is responsible for oversight of the FASB that issued those rules.

Additionally, although the SEC's cost-benefit study does a good job of detailing assumptions underlying its methodology - including difficulties in obtaining certain data - it is possible further work could be done with alternative assumptions and information.

Here are some verbatim excerpts from the SEC study:

For Section 404(b) compliant companies, the largest cost component is internal labor costs— which can comprise more than 50 percent of the total compliance cost—followed by the estimated portion of total audit fees attributed to ICFR (404(b) audit fees), outside vendor fees, and non-labor cost (see Table 8). [pdf pg 7, printed pg 9, SEC study]

It is important to note that the estimates of internal labor costs presented in this report are based on an assumption about a reasonable hourly rate. The rate adopted for internal labor is $121 per hour, consistent with the rate quoted as of September, 2008 for a junior accountant cited in a report on salaries prepared by the Securities Industry and Financial Markets Association (SIFMA), to which the Commission frequently refers in its rulemakings. This is at the low end of cost estimates that are provided in the SIFMA report for accounting and related services, and above the rate of $50/hour (or $100,000 for 2000 hours) that is assumed in a series of Financial Executives International (“FEI”) reports of survey findings relating to the costs of compliance with Section 404 that date back to 2005. Although our assumed rate is within the range of reasonable estimates for evaluating the overall costs of compliance, it is not intended for use in estimating the cost to an individual company. [pdf pg 14, printed pg 12, SEC study]

Overall, on average, respondents provided estimates of audit fees that are lower than what is reported by Audit Analytics. This is consistent with the disparity between the relatively broad definition of audit fees that applies in SEC filings from which Audit Analytics collects data and the comparatively narrow definition of audit fees provided in the survey questionnaire. Moreover, the differences are significant among the medium ($75-700 million) and larger (>$700 million) companies only, precisely where the broad definition of audit fees adopted for the purpose of SEC’s filings is most likely to lead to a discrepancy relative to the narrower definition in the survey. [pdf pg 37, printed pg 35, SEC study]

The evidence on the experiences of larger companies may be useful in evaluating the extent to which additional improvements to the implementation of Section 404(b) should be undertaken before it becomes applicable to non-accelerated filers. Notwithstanding, it is important to highlight that the analysis in this report is not designed to provide compliance cost estimates for companies that have yet to comply with the relevant requirements of Section 404. [pdf pgs 3-4, printed pgs 1-2, SEC study]

Based on the above, it is possible that further analysis could be done using alternative assumptions or methodology.

Cent two: However, an alternate view could be that the cost study under the Garrett/Adler amendment, aimed at considering the impact on companies with between $75 million and $250 million market cap, could potentially undo compliance by companies that are already required to comply with Sarbox 404b, and presumably may have already integrated the 404b internal control audit into their preexisting financial statement audit.

This could be viewed by some as raising different issues than the exemption of smaller companies with less than $75 million market cap (which have yet to be required to comply with 404b) as set forth in the remainder of the Garrett/Adler amendment. As noted in some of the articles linked above, although some parties favor exemptions, some strongly object to exemptions. For additional views on this topic, see Jim Peterson's Nov. 1 post in his Re: Balance blog.

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Tony DiGirolamo said...

Sarbanes Oxley 404a and b were a costly and unnecessary solution to the problem. It has driven business away from our stock exchanges and ingnores the fact that the huge frauds at the time were at the top of the companies like Enron, Adelphia, MCI, Health South etc. These are resolved by making the chief executive, CFO and key people in the organization sign certifications that they know and approve of their financials.

Repeal the whole internal control section except to say that companies are expected to have controls!!!
Tony DiGirolamo

dvogel001 said...

I already got a phone call from a small company that is not going to do anything because of the threat of no 404b compliance in the ammendment.

If there is no audit, then companies will not implement internal controls on their own and leave themselves in a 2nd class position with their peers.

In the end this will make these companies 2nd class public companies with less ability to raise capital. Bad move.

Sarbanes-Oxley compliance does not need to be costly, these studies are not accurate because companies throw all sorts of unrelated costs into them in order to deflect other cost overruns.

dvogel001 said...

Complying with SoX 404 is already pretty much voluntary. You can simply report that you have material weaknesses over your financial reporting due to financial constraints and incur no costs.

Now these companies will be allowed to do that and not inform investors that their investment is less controlled than a equivalent company that has such internal controls built into their processes.

Bob said...

SOX rules, including 404, were passed to protect the investor. If the level of documentation, testing, and remediation of control weaknesses required by SOX 404 is important for an investor in a Fortune 500 company it should be equally important for an investor in a small company. If SOX is overkill repeal it. If SOX is appropriate enforce it across the board. When John Q. Public invests $1000 they need equal protection, not different levels of protection driven by market cap. NO SMALL CAP EXEMPTION!!
Bob Kirk