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SEC Seeks Public Comment as Agency Conducts Dodd-Frank Mandated Study of Impact of 404(b) of Sarbanes-Oxley

By Jim Hamilton

The SEC has requested public comment on a wide range of issues on the Sarbanes-Oxley internal control audit attestation provision, Section 404(b), as it begins a Dodd-Frank mandated study on how to reduce the burden of 404(b) compliance for companies whose public float is between $75 million and $250 million. The Commission set forth 22 topics, plus a catch all, on which it would like to receive input, ranging from whether SEC or PCAOB guidance could reduce compliance burdens to the efficacy of a complete exemption from 404(b). The SEC must complete the study and report to Congress within nine months of Dodd-Frank?s enactment. The comment period is 45 days.

Section 404(a) of Sarbanes-Oxley requires that annual reports filed with the SEC must be accompanied by a statement that company management is responsible for creating and maintaining adequate internal controls and a further statement assessing the effectiveness of those controls. Section 404(b) requires the company's outside auditor to report on and attest to management's assessment of the company's internal controls. Section 404(a) was left untouched by Dodd-Frank and thus the SEC study will not evaluate its compliance burden.

Section 989G was one of the most contentious provisions of the Dodd-Frank Act. Sponsors of the provision emphasized that 989G will provide stability and predictability for small companies by permanently exempting them from costly regulations. In their view, the "one size fits all" regulatory approach to implementing section 404 of Sarbanes Oxley has had a disproportionately negative impact on small and medium sized companies. But Rep. Paul Kanjorski noted that this Sarbanes-Oxley exemption had no place in reform legislation designed to enhance investor protection. (Cong. Record, June 30 2010, H5238).

Ultimately, Section 989G exempted smaller reporting companies from the auditor attestation provisions of Section 404(b), while still requiring them comply with Section 404(a). Section 989G also mandates that the SEC study and report to Congress on methods that would reduce compliance for companies whose market capitalization is between $75 million and $250 million. The statute also commands that the SEC examine whether a complete exemption for such companies from Section 404(b) compliance would encourage companies to list on exchanges in the United States in their initial public offerings.

Section 989I added a follow-up GAO study on the impact of the permanent exemption from 404(b) bestowed by Section 989G. The GAO study will examine matters such as the frequency of accounting misstatements and investor confidence in the integrity of financial statements so, in Senator Dodd?s words, Congress ``can understand its effects.?? (Cong. Record, July 15, 2010, S5930).

Since neither the Dodd-Frank Act nor SEC rules define ?market capitalization,? the SEC decided to use a company?s public float as an appropriate measure of market capitalization. Public float, which is the aggregate worldwide market value of an issuer?s voting and non-voting common equity held by its non-affiliates, is the measure used in Commission rules for determining accelerated filer and large accelerated filer status. In addition, the SEC has used public float historically in its actions to phase issuers into Section 404 compliance.

In addition to the statutorily mandated study topics, the SEC asks for quantitative and qualitative information about the trends of the internal and external costs of having the outside auditor attest to management?s assessment under Section 404(b), as well as the current cost of auditor attestation in relation to the overall cost of compliance with all of Section 404. The SEC also seeks comment on the characteristics of internal controls, management?s evaluation process and the corporate governance of companies in the study that distinguishes them from other companies, as well as any unique audit planning and performance characteristics they may have.

More broadly, the Commission inquires about the incremental effort preparers and auditors must undertake to comply with the auditor attestation requirement of Section 404(b) for an integrated audit beyond the efforts that would already be incurred to comply with the requirements for a financial statement only audit, including the requirement to evaluate internal controls in connection with such an audit.

The SEC would also like to know if PCAOB Auditing Standard No. 5, with its focus on risk and materiality, scalability, tailoring of testing to risk, and use of the work of others, has reduced costs of compliance with Section 404(b) versus the earlier PCAOB Auditing Standard No. 2. Similarly, commenters should address how other PCAOB initiatives, such as its staff guidance for auditors of smaller public companies, have reduced the burden of complying with Section 404(b). On the same theme, the SEC asks if additional SEC or PCAOB guidance could further reduce the burden of complying with the auditor attestation requirement, while maintaining investor protection. Concomitantly, what is the degree to which investor protection, investor confidence, and the cost of capital would increase or decrease as a function of each specific recommendation by which the Commission, the PCAOB, or others might reduce the burden of complying with Section 404(b).

Importantly, the SEC also asks about the potential effect of a complete exemption from Section 404(b) on matters such as: raising capital; engaging in mergers, acquisitions and similar corporate transactions; and attracting and retaining qualified independent directors. In addition, the SEC would like to k now if auditor attestation reports on internal control over financial reporting enhances confidence in management?s assessment of the effectiveness of its internal controls, improves the reliability of financial reporting and improves the prevention and detection of fraud and other misconduct.

A catch all request asks for any other information that commenters would like the Commission to consider in regards to the study.

Full post as published by Jim Hamilton's World of Securities Regulation on October 18, 2010 (boomark / email).