At the final meeting yesterday of the SEC Committee on Small and Emerging Companies (apparently soon to morph into the Small Business Capital Formation Advisory Committee), the Committee finalized the discussion draft of its Final Report to the SEC and heard presentations on SOX 404(b), the most recent bête noire of deregulation advocates. (The Committee also heard a presentation on Rule 701, which will be addressed in a subsequent post.)
A number of Committee recommendations have already been adopted, but there are others that the Committee recommends that the SEC continue to pursue:
1. Facilitating Exempt Offerings
A. Finders In light of the difficulty of identifying potential investors, together with the lack of regulatory certainty surrounding the use of finders and others acting in a similar capacity, the Committee recommended that the SEC take action urgently to adopt rules providing regulatory certainty for finders, private placement brokers and platforms not registered as broker-dealers involved in primary and secondary transactions of unregistered securities. In the meantime, the Committee requested that the staff provide clarifying guidance. The Committee advised that it “considers this issue to be critical for many aspects of capital formation, and is disappointed that, despite repeated and longstanding requests, the Commission has not taken actions to help address the concerns.” B. Accredited Investor Definition The Committee considers the “accredited investor” definition to be “a centerpiece of Regulation D,” and, in 2015 and 2016, made recommendations to the SEC urging that any changes to the definition “do no harm.” In the Committee’s view, raising the individual income and net worth “would considerably decrease the number of households that qualify as accredited investors,” and have a disparate impact on areas with a lower cost of living (and, typically, lower venture capital activity), as well as on women and minority entrepreneurs. The Committee expressed its support for “expanding the definition to take into account measures of sophistication, regardless of income or net worth, thereby expanding rather than contracting the pool of accredited investors. That said, simplicity and certainty are vital to the utility of any expanded definition of accredited investor, so any non-numerical criteria should generally be ascertainable with certainty.”
2. Reporting Companies
A. Scaled Disclosure The Committee believes that public company disclosure requirements disproportionately burden smaller companies in terms of cost and compliance time. The Committee has previously recommended that the SEC harmonize the jumble of rules applicable to the various categories of small companies, including extending to SRCs the application of the small-company disclosure accommodations generally afforded to EGCs. (See this PubCo post.) In addition, the Committee has recommended that the current cap for SRC status be raised and, in 2016, the SEC proposed to raise the financial cap from “less than $75 million” in public float to “less than $250 million.” (See this PubCo post.) The Committee urged the SEC to finalize this rule, and to make similar changes to the definition of “accelerated filer” by raising the cap from a public float of less than $75 million to a public float of $250 million or more, but less than $700 million. This change would affect the timing of the filing of periodic reports and the requirement that accelerated filers provide an auditor attestation report under SOX 404(b). The Committee has also recommended that the accommodations made for EGCs with respect to disclosure requirements also be extended to SRCs. B. Board Diversity The Committee observed that “[b]oard diversity has been associated with improved competitiveness and talent management, greater access to capital, more sustainable profits, and better relations with stakeholders and therefore plays an important role in capital formation for small and emerging companies.” Although, in 2009, the SEC adopted rules requiring disclosure regarding consideration of diversity in identifying board nominees and diversity policies, the rules had no definition of diversity and companies have tended to define it very broadly. At the end of the day, the Committee contended, “the Rule has failed to generate information useful to stockholders, employees and customers in assessing board diversity.” As a result, the Committee recommended that the SEC amend the rule to “require issuers to describe, in addition to their policy with respect to diversity, if any, the extent to which their boards are diverse. The recommendation states that while, generally, the definition of diversity should be up to each issuer, issuers should include disclosure regarding race, gender, and ethnicity of each member/nominee as self-identified by the individual.” The Committee urged the SEC to proceed with this rule amendment.
3. Market Structure The Committee has raised the concerns that there is insufficient liquidity for the securities of small and emerging companies and that meeting listing requirements may not be feasible for smaller companies.
A. Secondary Market Liquidity Limited secondary market liquidity with regard to exempt offerings can deter potential investors and increase the cost of capital. The Committee previously made recommendations regarding facilitating the creation of a separate U.S. equity market for trading by accredited investors in the securities of smaller companies and federal preemption of state regulation of secondary trading in securities of Tier 2 Reg A issuers that are current in their ongoing reports. The Committee urged the SEC to move forward on this recommendation. B. Tick Size The Committee previously recommended that the SEC allow
“smaller exchange-listed companies to voluntarily choose trading increments or tick sizes greater than the current increment of one penny. The recommendation was rooted in the concept that something should be done to encourage market participants to provide more trading support for the equity securities of small and mid-cap companies. Widening spreads from the current one-penny increments could provide economic incentives that would encourage the provision of trading support to the equity securities of small and mid-cap companies. That support, in turn, could increase the liquidity for these securities, which could enhance the attractiveness of the IPO market for small companies and ultimately the ability of small and midcap companies to raise capital.”
The SEC is studying the results of a pilot to help assess the effect of tick-sizes on market quality for smaller companies, and the Committee encouraged the new committee to remain engaged on this issue.
SOX 404(b) The Committee also heard two presentations on SOX 404(b), the requirement to have an auditor attestation and report on management’s assessment of internal control over financial reporting, a requirement that has recently been much maligned.
In the first presentation, the representative of a Big 4 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 85 employees 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.
Some witnesses at the House subcommittee hearing held in July of this year, entitled “The Cost of Being a Public Company in Light of Sarbanes-Oxley and the Federalization of Corporate Governance,” called for the elimination, either entirely or for all companies outside of the Fortune 500, of the auditor attestation requirement. SOX 404(b), they urged, is time-consuming and expensive for smaller companies, diverting capital from other more important uses such as R&D. In addition, they charged, the definition of “internal control” is too broad, and the scope of “attest” imposed by the PCAOB is too exclusive. The hearing’s lonely voice in favor of the auditor attestation requirement contended that internal controls are the backbone of the financial statements and that some auditors view the attestation as more important than the audit itself. In addition, he maintained, knowing that a third party will examine their work will encourage companies to maintain better internal control. Moreover, even if SOX 404(b) were eliminated, there could very well be no beneficial effect on the number of public offerings, but the risk of financial scandal could dramatically increase. (See this PubCo post.)