In a move that reflects growing pressure against some provisions of the Sarbanes-Oxley Act of 2002, the US House of Representatives voted last week to exempt smaller public companies from the annual requirement to file an auditor’s attestation report on internal controls over financial reporting.
If it becomes law as part of the Investor Protection Act, the Garrett-Adler amendment would exempt non-accelerated filers – those public companies with market capitalizations below $75 million – from Sarbanes-Oxley Section 404(b). That section requires a public company’s auditors to attest to, and report on, the annual assessment made by management of the company’s internal controls. The recent House vote arose out of concerns that the costs of implementing Section 404(b) for smaller public companies outweigh the benefits.
"Burdensome regulations on small businesses hurt our economy," said Congressman John Adler, a member of the House Financial Services Committee. "As our economy begins to rebound, allowing small businesses to grow is crucial. This reform will help keep and create jobs for hard-working Americans."
Certain members of Squire Sanders advised Congressman Adler and members of his staff on the preparation of the amendment.
The amendment would require that the SEC and the Comptroller General conduct a study to determine how the burdens of Section 404(b) compliance could be reduced for companies with a market capitalization of between $75 million and $250 million, while maintaining investor protections. The study would also need to consider whether a reduction of compliance burdens or a complete exemption from Section 404(b) would encourage such companies to list their shares on US stock exchanges in their initial public offerings.
It is expected that creating an exemption from the Sarbanes-Oxley Act for smaller companies will allow them to access the public market on a faster time frame. "This could result in more rapid liquidity for venture capital and private equity funds that have invested in those companies, and in turn could lead to greater asset class allocation by pension fund investors in venture capital and private equity funds, especially if the exemption is extended to issuers with market capitalization in the $250 million range. This financial paradigm should generate increased financing for smaller companies and could result in additional job creation for companies in many sectors, including technology, renewable energy and life sciences, especially in geographic areas where venture and private equity funds have a strong presence, such as New York, New Jersey, Massachusetts, Georgia, Texas, Washington and California," said Arman Pahlavan, co-chair of the Squire Sanders private equity and technology practice. In addition, if enacted, the Garrett-Adler amendment would encourage US-based companies to continue to use the US securities exchanges to list their stocks rather than seek overseas markets for that purpose.
The SEC has delayed implementation of Section 404(b) for non-accelerated filers in past years, but stated recently that there would be no further extensions beyond the current June 2010 deadline. The Garrett-Adler amendment would effectively overturn the SEC on that point and make the exemption permanent.
Compliance with Section 404(b) is a significant barrier for many private equity-backed portfolio companies because such compliance requires that companies expend significant internal resources and legal and accounting costs to assure its auditors of its management assessment of internal controls. Many of these smaller companies believe that regulation intended to address problems at larger companies such as AIG, Enron and WorldCom should not apply to them because they are sufficiently regulated by current SEC rules and regulations. "Many of these issuers believe that smaller companies could not cause the same kind of disruption in the financial markets that abuses of the system by larger entities could cause. As such, these companies believe that they bear a disproportionately larger cost of compliance with Sarbanes-Oxley for the greater good of maintaining investor protections in the US securities markets," noted Mr. Pahlavan.
To become law, the Garrett-Adler amendment still must receive final approval by the House and Senate along with the rest of the Investor Protection Act, and be signed into law by the President.
This congressional action comes just a few days after the US Supreme Court heard oral arguments in Free Enterprise Fund v. PCAOB, a case challenging the constitutionality of the Public Company Accounting Oversight Board (PCAOB), which was created by the Sarbanes-Oxley Act. The plaintiffs in the suit argued that the PCAOB, whose members are selected by the SEC, violates the Constitution’s "appointment clause," which requires that senior executive branch officials be appointed by the President and confirmed by the Senate. A Supreme Court ruling that the PCAOB is unconstitutional could significantly affect the regulatory framework created by Sarbanes-Oxley.