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Advisory Committee Approves Final Report with Section 404 Recommendations

The Advisory Committee on Smaller Public Companies, at its last meeting on April 20, approved a final report for submission to the SEC. The vote was unanimous to submit the report, but three committee members dissented from the recommendations regarding Sarbanes-Oxley Act section 404. Janet Dolan, who headed the section 404 subcommittee, said that if the committee could do anything differently, it would not use the word "exemption" in connection with the reach of the internal controls requirement. She noted that the SEC's numerous postponements of the implementation of section 404 for smaller companies were, in effect, an exemption, while the committee proposes that additional corporate governance measures be adopted to balance any decision not to impose the section 404 requirements on smaller public companies.

John White, the director of the SEC's Division of Corporation Finance, said he had been briefed about the committee's work by his predecessor, Alan Beller, and had read the latest draft reports. The drafts reflect a thoughtful and comprehensive product, he said. White assured the committee that he and others at the SEC will look at the report with an open mind and will give every recommendation serious consideration. No final determinations have been reached, he said.

The committee reviewed a number of recent draft changes before voting on the recommendations. All but one of the members voted in favor of the recommendations to scale the securities regulations for smaller companies. The committee members unanimously approved the recommendations on corporate governance, disclosure and capital formation and those on accounting standards. The views of those who dissented from the section 404 recommendations will be included in the final report. Kurt Schact, the executive director of the CFA Centre for Financial Market Integrity, said he spoke for the under-represented investors' voice on the panel and believed that the section 404 recommendations were forsaking the primary tenet of the committee's charter --investor protection.

A number of committee members took issue with Schact's view that he was the only voice for investors among the 21 members. Robert Robotti pointed out that his firm provides broker-dealer and investment advisory services relating to small and mid-cap companies, in which it also invests. Jack Herstein, the assistant director of the Nebraska Bureau of Securities, noted that he was an observer representing the interests of the North American Securities Administrators Association. He said that if he had a vote, he would support the section 404 recommendations. Drew Connolly III, the president of IBA Funding said he too was an investor advocate and invests in microcap securities. Ted Klein is on the board of directors of the National Venture Capital Association and said he too speaks for investors.

Connolly complained that on the eve of every Advisory Committee meeting there was an attack by the press. He said these were coordinated attacks by gratuitous and mean-spirited former officials seeking to remain relevant in this debate.

E. David Coolidge, III, the vice chairman of William Blair & Co., urged the SEC to pay close attention to international competitiveness. He said there is growing evidence that section 404 has created a reluctance to enter U.S. markets or to remain listed. He believes that section 404 has damaged the U.S.'s reputation internationally and believes it is a serious issue on the capital formation front.

Mark Jensen, with Big Four accounting firm Deloitte & Touche, said the SEC should focus on the areas in which the committee members agree. Jensen, who dissented on the section 404 recommendations, said there was a general agreement that the costs are too high, especially for small companies. The disagreement is over how to fix it. Alex Davern, the chief financial officer for National Instruments Corp., noted that the two Big Four committee members dissented to the section 404 recommendations but the Big Four is not a player in the microcap market.

The committee's final recommendation is that, unless and until a framework for assessing internal control over financial reporting for microcap companies (those with less than $250 million but more than $10 million in annual revenues) is developed, the SEC should provide exemptive relief from the requirements of section 404 as long as the companies adopt certain corporate governance controls. The corporate governance controls would include adhering to the audit committee requirements of 1934 Act rule 10A-3 and the adoption of a code of ethics as outlined in Regulation S-K Item 406. Microcap companies would still have to maintain effective internal controls over their financial reporting and apply CEO and CFO certifications to the disclosures about their internal controls. They would also have to disclose information about material weaknesses.

The committee also recommends that until an effective framework is developed, smaller public companies would be exempt from the external auditor involvement in the section 404 process. If the SEC determines that the audit attestation is required, the committee recommends that the SEC follow a more cost-effective standard, known as ASX, in which the external audit is conducted with respect to the design and implementation of internal controls.