In this speech before the 36|86 Entrepreneurship Festival in Nashville, Tennessee, SEC Chair Jay Clayton discussed, among other topics, the coming agenda for public companies designed to “encourage capital formation for emerging companies seeking to enter our public capital markets.” The main topic was the plan to revisit the thresholds that trigger the SOX 404(b) requirement to provide an auditor attestation report on internal control over financial reporting. One thing is pretty clear from this speech: odds are excellent that relief from SOX 404(b) is in the offing for more small companies.
First, Clayton focused on a point that he viewed as “often misunderstood”: that even those companies that are not now required to obtain a SOX 404(b) auditor attestation must still “establish, maintain and assess the effectiveness of ICFR, and, even if not engaged to report on ICFR, independent auditors are still responsible for considering ICFR in the performance of their financial statement only audits. In considering ICFR, independent auditors can better plan their audits and provide management and audit committees with observations about the company’s ICFR. I believe this scaled approach has proven to be appropriate for smaller reporting companies and again reflects the perspective that one size regulation of public companies does not fit all.” To support that last point, he highlighted the difference in size between the 50th largest exchange-listed company (market cap of approximately $100 billion) and the median exchange-listed company (market cap of less than $1 billion). Moreover, he pointed out, many companies could benefit from relief as there are more than 1,200 exchange-listed companies with a market cap of less than $250 million. (In connection with the expanded definition of “smaller reporting company”—an expansion similar to the one likely under consideration here—the staff estimated that 966 additional companies would be eligible for SRC status in the first year. See this PubCo post.)
Other potential beneficiaries of relief, according to Clayton, are companies with little or no revenue, such as many biotechs. In those cases, he asserted, the money that would otherwise be used for the SOX 404(b) attestation “could instead be used to hire new scientists to advance life-enhancing or life-saving developments.” He concluded by reminding us that he had directed the staff to come up with potential amendments to reduce the number of companies subject to SOX 404(b), while, of course, maintaining appropriate investor protections.
Since the proposal to expand the SRC definition was issued in 2016, there has been a significant push to include a modification of the SOX 404(b) requirement as part of that proposal. In particular, the application of SOX 404(b) to smaller companies has been subject to a torrent of criticism, including from the SEC’s Advisory Committee on Small and Emerging Companies. In its final report in 2017, that Committee reiterated its recommendation to increase the threshold for “accelerated filers,” 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.) Why the anguish over SOX 404(b)? That provision has 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. 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.)
The other effort to enhance capital formation that Clayton highlighted in his speech was a staff project to expand the availability of “testing the waters” beyond EGCs. The test-the-waters provisions in the JOBS Act significantly relaxed “gun-jumping” restrictions by permitting an EGC, and any person acting on its behalf, to engage in pre-filing communications with QIBs and institutional accredited investors to determine the potential level of investor interest before committing to the expensive and time-consuming prospectus drafting and SEC review process. (See this Cooley Alert.) Clayton noted that he expected the SEC to consider “this initiative in the coming year.”
Finally, with regard to private capital-raising efforts, Clayton acknowledged that the current exemptive framework needed a comprehensive review “to ensure that the system, as a whole, is rational, accessible, and effective,” and indicated that the staff was working on a concept release that would attempt to harmonize the various exemptions. In that regard, he characterized the current framework as “an elaborate patchwork” that would not likely exist as is if the SEC were starting with blank slate. In particular, he noted:
- “We should evaluate the level of complexity of our current exemptive framework for issuers and investors alike, and consider whether changes should be made to rationalize and streamline the framework.
- For example, do we have overlapping exemptions that create confusion for companies trying to navigate the most efficient path to raise capital?
- Are there gaps in our framework that impact the ability of small businesses to raise capital at key stages of their business cycle?
- We also should consider whether current rules that limit who can invest in certain offerings should be expanded to focus on the sophistication of the investor, the amount of the investment, or other criteria rather than just the wealth of the investor.
- And we should take a look at whether more can be done to allow issuers to transition from one exemption to another and, ultimately, to a registered IPO, without undue friction.