What’s next for the House after taking on Dodd-Frank in the Financial CHOICE Act? Apparently, it’s time to revisit SOX. The Subcommittee on Capital Markets, Securities, and Investment of the House Financial Services Committee held a hearing earlier this week entitled “The Cost of Being a Public Company in Light of Sarbanes-Oxley and the Federalization of Corporate Governance.” During the hearing, all subcommittee members continued bemoaning the decline in IPOs and in public companies, with the majority of the subcommittee attributing the decline largely to regulatory overload. A number of the witnesses trained their sights on, among other things, the internal control auditor attestation requirement of SOX 404(b). Is auditor attestation, for all but the very largest companies, about to hit the dust?
According to the Committee Memorandum, the hearing was “an overview of current issues public companies face in light of the Sarbanes-Oxley Act of 2002, which turns 15 years old this month, federal corporate governance mandates, and other factors that may impact a company’s decision to go or remain public.” The hearing was intended to “provide the Subcommittee with the background and foundation to consider legislative proposals to promote capital formation and ease unnecessary regulatory burdens faced by U.S. public companies to ensure that the U.S. capital markets remain the ‘gold standard’ and the preferred venue for companies to raise capital.” The witnesses included representatives of the Chamber of Commerce, the NYSE, the Competitive Enterprise Institute and a law professor.
[Based on notes, so the usual caveats apply.]
The opening statement of Subcommittee Chair Bill Huizenga argued that compliance with the SEC’s extensive disclosure regime is not only costly but also exposes companies’ sensitive information. He blamed former SEC Chair White for focusing on regulations designed to cure societal ills instead of regulations to promote the SEC’s core mission, specifically highlighting the conflict minerals and pay-ratio rules (apparently overlooking the fact that those rules were congressionally mandated by Dodd-Frank). Subcommittee Vice Chair Randy Hultgren contrasted the decline in public companies in the U.S. from 1996 to 2012 (down 49%) with a 28% increase overseas during the same period. That decline, he indicated, reflects “mounting evidence” of regulatory burden. He noted in particular the “hijacking” of the shareholder proposal process to remedy social justice concerns. Ranking member Carolyn Maloney offered a different perspective, reminding all that SOX was passed overwhelmingly on a bipartisan basis in response to a wave of corporate scandals involving very large companies that destroyed investor confidence in companies’ financial statements generally. Federal regulation of corporate governance matters affecting financial statements, she continued, was not new, but rather has been in place for over 80 year; it is not necessarily an issue of solely state law.
The arguments made by the witnesses advocating more deregulation included the following:
- Mr. and Ms. 401(k) are no longer the beneficiaries of the explosive growth that previously occurred post-IPO; now, that growth is largely occurring pre-IPO and those benefits are accruing primarily to pre-IPO accredited private investors.
- The IPO is also an inflection point for job creation, with 75% to 90% of jobs created by public companies post-IPO.
- Regulatory mission creep is decreasing the attractiveness of public markets, and the costs of compliance are deterring companies from going public and, in some cases, into merger activity as an alternative. The problems are related more to disincentives on the public side rather than the attractiveness of the private markets at this time.
SideBar: At recent meetings of an SEC advisory committee and an SEC-sponsored forum, participants promoted a different view of the causes underlying the decline in public companies. Several indicated that the decline largely reflected acquisitions and delistings, as well as the significant extension of the timeframe to IPO; now, according to one participant, there is more concern with forcing companies to go public too early, and less mature companies tend not to be on the receiving end of calls from investment banks, as they may not yet be considered to be the caliber of company necessary to satisfy current market expectations.
One panelist reported that, when a number of CFOs were asked why they would decide not to go public, at the top of the list was the need to maintain decision-making control. In the private market, another panelist suggested, companies and investors have a kind of unspoken “pact” about long-term strategy. But, said one panelist, the rise of hedge-fund activism in tech and other product-cycle-driven public companies—a relatively recent phenomenon—has fueled concerns among founders and other management that they will be hampered in pursuing long-term strategic goals by activists with short-term perspectives. These companies fear that activity that may have significant long-term payout, but a near-term adverse price impact (e.g., M&A activity, change in product strategy, substantial investment in R&D), will draw scrutiny and intervention from hedge-fund opportunists.
At the bottom of the CFO list of reasons not to go public was the burden of regulatory compliance. As one academic on the panel explained, while regulatory cost has been the dominant narrative, that narrative ignores the impact of deregulation of private-capital raising—it’s now much easier not only to raise private capital (e.g., changes to Reg D) but also to stay private (e.g., changes to the Exchange Act registration threshold). With low interest rates, debt has also been an attractive option for funding in lieu of an IPO. In addition, markets have provided more opportunities for liquidity through secondary trading of privately held shares. The panelist also argued that private companies enjoy the benefit of information asymmetry relative to public companies, which are subject to much more significant disclosure requirements. Changes in the market were also cited as a cause for the decline, including the growth of passive index funds. (See this PubCo post.)
- On the one hand, there have been regulatory issues of “benign neglect,” such as failures to regulate proxy advisors and to prevent special interest activists from misusing the 14a-8 shareholder proposal process, and, on the other hand, problems relate to intrusive interventions, such as using the federal securities laws to affect a humanitarian crisis (conflict minerals) and to address other environmental, social and governance issues.
- Shareholder proposals related to environmental, social and governance issues have picked up steam—although they are not related to enhancing the underlying value of the shares—because the SEC has allowed them to go forward.
- The expansion of disclosure requirements to include information that is not material to investors has resulted in disclosure overload in proxy statements and other disclosure documents.
- Some disclosure requirements–pay ratio was mentioned here–may actually be detrimental to companies, citing in particular the adoption by the City of Portland of a surtax on companies that pay their CEOs more than 100 times the median pay of their rank-and-file workers. (See this PubCo post.)
- The auditor attestation requirement of SOX 404(b) is 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” is too broad, and the scope of “attest” imposed by the PCAOB is too exclusive. (One witness provided the example of a company that had been asked to document, as an internal control, the employees who had office keys.)
- The prevalence of questionable class-action litigation is also a deterrent to undertaking an IPO.
- The focus on short-term results is problematic. Stock buybacks represent a massive reallocation of capital away from public companies.
- Short sellers can engage in manipulative trading behaviors that discourage long-term investments.
- More transparency is needed with regard to conflicts of interest at the proxy advisory firms, as well as the process followed for developing recommendations. For smaller companies, the process is even more opaque, errors are harder to correct and there are fewer opportunities for engagement. (One witness cited as an example of a conflict, the position of the proxy advisors in favor of solicitation of say on pay on an annual basis, while they also have a pecuniary interest in precisely that result.)
- The abuse of Rule 14a-8 by a few corporate gadflies pushing special interests wastes corporate time and money and frustrates the majority of shareholders; the reversal of the Whole Foods no-action decision regarding conflicting proposals and related Staff Legal Bulletin represent an abdication by the SEC of its role as a gatekeeper.
SideBar: You might recall that, in 2015, the Corp Fin staff issued an SLB regarding Rule 14a-8(i)(9), the exclusion for conflicting proposals, which narrowed the application of the exclusion by redefining the meaning of “direct conflict.” Under the new guidance, the question became “whether a reasonable shareholder could logically vote for both proposals” because both seek a similar objective. If so, the proposals are not in “direct conflict.” The staff’s new interpretation made it substantially more challenging for companies to rely on the exclusion. The guidance was largely in response to a surprising conflict over the application of that exclusion that arose originally in the context of a shareholder proposal for proxy access that had been submitted to Whole Foods. In that instance, the SEC staff had originally granted the company’s no-action request to omit the a proxy access shareholder proposal from its proxy statement. That proposal would have permitted shareholders holding at least 3% of the company’s voting securities to nominate up to 20% of the board and to include those nominees in the company’s proxy statement. In its no-action request to the SEC, Whole Foods advised that it was submitting a conflicting proxy access proposal at the same meeting that included different terms; for example, it would allow any single shareholder owning at least 9% of the company’s common to submit nominations to be included in the company’s proxy statement. In view of its success, a significant number of companies then followed the Whole Foods model, although most opted for lower thresholds in their conflicting management proposals. The Whole Foods shareholder proponent then requested that the entire SEC reconsider and reverse the Whole Foods decision. The SEC did reconsider the issue and the SLB followed. (See these PubCo posts: 12/8/14, 1/5/15, 1/20/15, 2/11/15, 3/19/15 and 10/22/15.)
Arguments made by the law professor, the single witness advocating the benefits of SOX:
- Most of the decline in the number of public companies occurred with bursting of the dot-com bubble and prior to the adoption of SOX, suggesting that increased regulation is not the main deterrent. Much of the decline can actually be attributed to the impact of the JOBS Act, which facilitated private capital-raising and, by raising the Exchange Act registration threshold, allowed companies to stay private for longer periods.
- So far in 2017, there has been a significant jump in IPO activity.
- Following a series of financial scandals, SOX strengthened boards and board committees, improved audit quality and promoted investor confidence in financial integrity and corporate disclosures. Instead of looking at lowering the cost, the public markets would be enhanced by looking at how to improve investor confidence.
- Internal controls are the backbone of the financial statements; some auditors view the attestation as more important than the audit itself.
- Knowing that a third party will examine their work will encourage companies to maintain better internal control over financial reporting.
- 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 404(b) went into effect, there were over 1,000 restatements in each year.
SideBar: According to Audit Analytics, the percentage of adverse internal control auditor attestations has decreased from 15.7% in 2004 to 5.3% in 2015. In its 2015 Financial Restatements Report, Audit Analytics “found that after the implementation of SOX there was a massive increase in financial restatements that peaked at 1,851 in 2006. That number declined significantly to just 737 in 2015.” In addition, it “found that the financial impact on net income has also declined. Restatements of $3 billion to $6 billion were made in each year between 2002 and 2006. Since 2008 only one year had a restatement that has impacted net income by more than $1 billion.”
- If SOX 404(b) were eliminated, 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.
- The system of disclosure needs to be modernized, and the starting point should be disclosure effectiveness, not overload.
- Shareholder proposals submitted reflect the issues that shareholders care about, and proposals in the governance area typically garner a lot of shareholder support. Recently, environmental shareholder proposals submitted to three large energy companies won majority support. (See this PubCo post.)
- Shareholder proposals are typically advisory only, provide useful information to boards about shareholder concerns and encourage dialogue between boards and shareholders.
Some of the recommendations proposed by these witnesses included:
- Eliminate, either entirely or only for companies outside of the Fortune 500, the auditor attestation requirement of SOX 404(b).
- Narrow the definition of internal control over financial reporting to processes that have been proven effective and expand the notion of “attest” to allow it be performed by more, less expensive audit and other firms.
- Prevent the PCAOB from adopting rules that increase the burden for companies.
- In connection with class action litigation, move to a system of loser pays.
- Extend the benefits of EGC status beyond five years.
- Require disclosure of short-sale transactions.
- Reduce disclosure overload/ modernize the disclosure system to make it more effective.
- Increase the eligibility thresholds for resubmission of shareholder proposals.
- Harmonize the definitions of materiality used by the SEC, PCAOB and FASB in conformance with the definition in TSC Industries v. Northway.
- Increase the requirement for transparency for proxy advisory firms by requiring registration and require that they permit more company input into their recommendation process.
- Reexamine the SEC’s position on some of the exclusions for shareholder proposals, such as its recent position limiting the use of the exclusion for conflicting proposals.
- To avoid the prospect of regulation, companies should make efforts on their own to address issues such as board diversity (per the Chamber representative).
Of course, the Financial Choice Act of 2017, which was passed in the House, but is reportedly unlikely to go anywhere in its current form in the Senate, would address a number of these issues, at least in part. (See this PubCo post and this PubCo post.) Will any further effort to advance the proposals addressed in this hearing take hold or will that effort be merely tilting at windmills?