Those of you who expected the SEC to go big and propose raising the current threshold for status as an “accelerated filer” to be commensurate with the cap for “smaller reporting companies” will be sorely disappointed. Nevertheless, the SEC did address the big elephant in the room—SOX 404(b)—with a narrowly tailored exception.

At an open meeting this morning, the SEC voted (by a vote of three to two, with Commissioner Robert Jackson dissenting) to propose amendments to the accelerated filer and large accelerated filer definitions that provide a narrow carve-out from these definitions for companies that qualify as smaller reporting companies and reported less than $100 million in annual revenues in the most recent fiscal year for which audited financial statements were available. As a result, if the proposal were adopted, those companies would no longer need to comply with the shorter timeframes applicable to accelerated filers and large accelerated filers for filing periodic reports. And, most significantly, the proposed revision would mean that those companies qualifying for the carve-out would no longer be subject to the SOX 404(b) auditor attestation requirement, which has been anathema to many deregulation advocates. Notably, companies with a public float between $75 million and $250 million would still be subject to the accelerated filer requirements unless their revenues were under the $100 million revenue cap. The proposal would also increase from $50 million to $60 million the transition thresholds for accelerated and large accelerated filers to become a non-accelerated filer and increase the threshold for exiting large accelerated filer status from $500 million to $560 million. In addition, the proposal would add a revenue test to the transition thresholds for exiting both accelerated and large accelerated filer status. (Here is the press release.) There is a 60-day comment period. (The proposing release has just now been posted. Check this space for updates.)

(Partially based on my notes, so standard caveats apply.)

You may recall that in June 2018, the SEC approved amendments that raised the SRC cap from “less than $75 million” in public float to “less than $250 million” and also included as SRCs companies with less than $100 million in annual revenues if they also had either no public float or a public float of less than $700 million. Those changes, however, ruined the alignment between the definitions of “smaller reporting company” and non-accelerated filer, with the result that some companies are now categorized as both SRCs and accelerated filers. The SRC adopting release indicated that many commenters took the opportunity to recommend that the SEC increase the public float cap in the accelerated filer definition commensurate with the cap in the new SRC definition, arguing that the costs associated with SOX 404(b) were burdensome and “divert capital from core business needs.” Although the SEC elected not to raise the accelerated filer cap at that time, notwithstanding the admitted additional regulatory complexity, Chair Clayton did direct the staff to formulate recommendations “for possible additional changes to the ‘accelerated filer’ definition that, if adopted, would have the effect of reducing the number of companies that qualify as accelerated filers in order to promote capital formation by reducing compliance costs for those companies, while maintaining appropriate investor protections.” Instead of raising the thresholds in the accelerated filer definition altogether, the staff crafted a more tailored exception that may perhaps be more palatable to those concerned about the possibility of eliminating the auditor attestation for entire group of SRCs.

In his statement at the open meeting, SEC Chair Jay Clayton characterized the proposal as a “retrospective review of one component” of SOX, observing that there are “many components” of SOX, including a number supporting the independent audit committee and enhanced auditor independence requirements, which have made significant contributions to the quality of financial reporting and are not affected by the proposal (a concept that Commissioner Roisman echoed as well in his statement). In addition, he emphasized that these SRCs will continue to be required to “establish, maintain, and assess the effectiveness of their internal control over financial reporting (ICFR).” Off-script, he also noted that, as part of the audit, auditors will continue to be required to assess ICFR. The difference will be the absence of the auditor attestation, which, for this subset of companies, was viewed to add disproportionate costs and was considered “unlikely to enhance financial reporting or investor protection.” In his view, the “proposed amendments are intended to reduce costs without harming investors for certain smaller public companies and, importantly, encourage more companies to enter our public markets…”

Clayton also made the point that the “retrospective review in this area” was not novel and, in fact, was also the subject of subject of Congressional review in the JOBS Act, with the determination to eliminate the SOX 404(b) requirement for “emerging growth companies”:

“That is, Congress, itself engaging in retrospective review, recognized that the compliance costs of certain aspects of Sarbanes-Oxley requirements do not scale with the size of the business, and those incremental and recurring costs can deter smaller companies from accessing our public capital markets….Notably, [the representation of these smaller companies] in our public markets has disproportionally decreased over the years. The lower-revenue companies affected by the proposed amendments generally have simpler financial statements. In fact, our economists do not expect that exempting these companies from the ICFR auditor attestation requirement would weaken the effectiveness of the ICFR or increase restatement rates compared to those companies that would remain accelerated filers….Investors in these companies will benefit from tailored requirements that will save costs that companies would be able to re-direct into growing their companies by investing in productive areas such as research and human capital.”

Corp Fin director Bill Hinman also emphasized that companies subject to the exception would remain subject to the ICFR management’s assessment requirement as well as the general requirement to assess ICFR as part of the audit. The low-revenue companies covered by the carve-out generally have less complex financial statements, he contended, and are less likely to have many of the typical control lapses, such as those related to revenue recognition. As a result, he maintained, the auditor’s attestation constituted a disproportionate burden on these companies but was less critical to their evaluation by the market (which would likely evaluate them at this point based on breakthrough potential rather than on their financial reporting). For example, Hinman said, 36% of companies affected by the proposal were in the pharma/biotech space. (Although these companies may have larger market caps, they are often in the early stages of product development and, therefore, frequently have no or extremely low revenues. As a result, they often have financial characteristics much closer to non-accelerated filers.)

In his statement, Jackson took issue with the proposal, which he characterized as a “roll back” of SOX 404(b). In essence, he criticized the proposal’s analysis of the costs of attestation as “based on data that’s over a decade old, and the proposal makes no real attempt to assess the investor-protection benefits of gatekeepers in our markets.” Indeed, Jackson and his staff conducted their own analyses based on more current data, and, as a result, he concluded that “it’s clear that this proposal has no apparent basis in evidence.” (Might that explain why the DERA representative at the open meeting kept referring to the economic analysis as “preliminary”?)

Harkening back to the debacles at Enron and WorldCom, Jackson argued that SOX 404(b) was adopted to “deter managers from fudging the numbers…. While paying auditors isn’t free, neither is fraud. And fraud is more likely when insiders are less careful about controls. That’s why, when we roll back protections like these, we can expect the cost of capital to rise; investors will either diligence the risk of fraud themselves or require higher returns to protect against that risk. There’s a tradeoff; and hard evidence from the market, not ideological intuition, should tell us how to strike that balance.” A key reason given for the proposal was to encourage more IPOs, he said, but that type of deregulatory effort has not been successful in the past, and that’s because “investors know better than Washington insiders about the value of protections like Section 404(b).” While the companies subject to the proposal may have found the costs of attestation most burdensome, “it’s equally possible that these are the firms—high-growth companies where the risk, and consequences, of fraud are greatest—where the benefits of the auditor’s presence are highest.”

More specifically, Jackson criticized the economic analysis for relying on data from 2004 showing “that companies with a public float under $75 million—the level under which auditor attestation is not required—seemed to ‘bunch’ under that threshold,” suggesting that they intentionally kept their floats low to avoid SOX 404(b) costs. Jackson’s own study using current data showed that the “bunching” phenomenon was no longer true: “That’s why, in 2011, the Office of our Chief Accountant examined the costs of the attestation requirement and reported to the Commission that there was no longer any ‘specific evidence that [any savings from rolling back 404(b)] would justify the loss of investor protections.’”

Jackson also contended that the proposal was flawed because it made “no serious attempt to evaluate the benefits of attestation.” So, his office studied

“how investors react to news of an internal control failure in two groups of companies: those that would receive a rollback of 404(b) under today’s proposals and those who would not. The evidence is striking. The data show we are proposing today to roll back 404(b) for exactly the group of companies where investors care about the benefits of auditor attestation most…. That result has many possible explanations, all of which are worth considering. One is that investors are concerned that companies of this size are particularly prone to accounting issues. But whatever the reason, the data show that investors care most about the information produced by the attestation requirement at exactly the firms that today’s proposal would exempt from Section 404(b). The views of the ordinary American investors who put their savings at risk in these companies deserve far more weight than this proposal gives them.”

In 2015, the SEC’s Advisory Committee on Small and Emerging Companies (now called the Small Business Capital Formation Advisory Committee) recommended that the SEC attempt to harmonize the jumble of rules applicable to the various categories of small companies and, specifically, that the SEC increase the threshold for “accelerated filers” to include companies with a public float of $250 million or more, but less than $700 million, with the result that the requirement to provide an auditor attestation report under SOX 404(b) would no longer apply to those companies. (See this PubCo post.) However, in the release proposing the change to the SRC definition in 2016, the SEC expressly rejected that Committee recommendation on the basis of the 2011 staff study to which Jackson referred, which found

“no specific evidence that any potential savings from exempting registrants with public floats between $75 million and $250 million from the auditor attestation provisions of Section 404(b) would justify the loss of investor protections and benefits to registrants from such an exemption. Rather, the staff found that accelerated filers (including those with a public float between $75 million and $250 million) that were subject to the Section 404(b) auditor attestation requirements generally had a lower restatement rate than registrants that were not subject to the requirements. Moreover, the staff found that the population of registrants with public floats between $75 million and $250 million did not have sufficiently unique characteristics that would justify differentiating this population of registrants from other accelerated filers with respect to the Section 404 auditor attestation requirements.”

The proposing release also observed that subsequent academic research on this topic was mixed. As a result, the SEC did not propose to raise the accelerated filer public float threshold or to modify the SOX 404(b) requirement as part of that proposal. The SEC did, however, request comment on the issue.

Since the SRC proposal was issued in 2016, there has been a torrent of criticism of the application of SOX 404(b) to smaller companies. In particular, SOX 404(b) has recently been scrutinized as a significant contributor to the type of regulatory overload that some argue has deterred companies from conducting IPOs. At a July 2017 hearing of the Subcommittee on Capital Markets, Securities, and Investment of the House Financial Services Committee, a number of the witnesses trained their sights on SOX 404(b), arguing that it was too time-consuming and expensive for smaller companies, diverting capital from other more important uses such as R&D. In addition, the definition of “internal control” was characterized as too broad, and the scope of “attest” imposed by the PCAOB was too exclusive. According to another witness, however, an EY report showed that, following the effectiveness of the SOX attestation requirement, from 2005 to 2016, the number of financial restatements declined by 90%, and the aggregate amount of net income involved in restatements declined from $6 billion to $1 billion. Initially, in the first two years after SOX 404(b) went into effect, there were over 1,000 restatements in each year. If SOX 404(b) were eliminated, a witness speculated, the result could very well be that there is no beneficial effect on the number of public offerings, but that the risk of financial scandal has dramatically increased. (See this PubCo post, this PubCo post and this PubCo post.)

Although Commissioner Peirce’s statement has not yet been posted, she indicated that, while she supported the proposal, she had reservations about its scope. The resulting complexity in the definitions, she said, required a navigation tool to comply. While she agreed that the proposal involved trade-offs, she would characterize them differently: in this case, the protection of auditor attestation versus more funds for R&D and less diversion of management time. If investors want this additional protection, she assumed they would speak up.

SideBar

In its final meeting in 2017, after hearing two presentations on SOX 404(b),the Advisory Committee on Small and Emerging Companies reiterated its recommendation to increase the accelerated filer threshold. In the first presentation, the representative of a Big Four accounting firm discussed the improvements seen in accounting quality as a result of SOX 404(b). According to studies, he said, investors see value in controls audits because the accounting becomes more reliable. According to a GAO study, companies exempt from controls audits had more restatements. In addition, another study showed that companies that had controls audits had higher valuation premiums and lower cost of debt. However, he recognized that there was also a cost involved in a SOX 404(b) audit, which he viewed as part of the cost of being public. Nevertheless, many smaller or newly public companies are exempt from the SOX 404(b) requirement: non-accelerated filers are exempt, meaning that about 50% of public companies do not have to have controls audits performed, and EGCs can be exempt for the first five years after going public. In addition, with an integrated audit, the incremental costs of the controls audit is just a fraction of, not double, the cost of the financial statement audit—well yeah, but he couldn’t say how big a fraction that was—and those costs tend to decline after the first audit. Reforms implemented in 2007 have also led to a decline in costs.

In the second presentation, the CEO of a small biotech came armed with specific recommendations: he advocated exemptions from SOX 404(b) for companies with either public float under $250 million or annual revenue under $100 million. While his proposal would apply to companies in industries across the board, it was particularly relevant to biotechs, especially those with no products yet on the market. Many of those companies, he said, had little revenue and few employees, and the cost of the controls audit would divert necessary funds from R&D. In one example, the cost of the controls audit for one small public biotech with fewer than 60 employees and a public float of $85 million added 1% to the company’s burn rate. He believed that SOX 404(b) just did not make sense in those circumstances. A committee member agreed, arguing that controls audits did not add much value: in one study, he said, 84% of restatements were not preceded by reports of material weaknesses; that is, the 404(b) audits failed. (See this PubCo post.)