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Inspector General Recommends Improvements to Corporation Finance Review Process

The SEC's Office of the Inspector General has issued a report on its evaluation of the Division of Corporation Finance's preliminary review process which includes three recommendations. OIG recommends that the Division enhance its consideration of risk factors when selecting companies for preliminary review, that it maintain surveillance of the largest companies and that it continue to manage its work loads more efficiently. The Division, having completed its first three-year cycle of reviews mandated by the Sarbanes-Oxley Act, believes that it has now established procedures to meet the review mandate.

OIG audited the Division's preliminary review process to determine whether there were areas in which improvements could be made. OIG noted that the Division has made substantial changes in the way it selects companies for further review, moving from a mechanical screening process to a more substantive preliminary review process. The Division typically conducts full reviews upon a company's initial entry into the federal disclosure system, usually through an initial public offering of securities. The staff also reviews contested proxy contests, tender offers and going private transactions since they may have a material impact on investor interests.

After a preliminary review, the Division's further review of selected filings focuses on the full disclosure of material information and corrections of material deviations from the SEC's rules, regulations and generally accepted accounting principles. OIG noted that the Division has been testing reports by a number of private vendors to see if they can help to identify companies with problems. OIG added that, if data tagging technology is eventually implemented for SEC filings, it should allow the staff to conduct financial analysis and to identify trends across companies.

OIG has identified and shared with the staff certain risk-based information that it believes will improve the staff's preliminary review process, including financial ratios and analyses, and trading data. OIG recommended that the Division consult with other offices, including the Office of Information Technology, the Office of the Chief Accountant and the Office of Risk Assessment to further enhance its consideration of risk factors. The Division should then provide guidance to the staff, as appropriate, OIG advised.

OIG observed that the Division generally relied on only one of the factors outlined in the Sarbanes-Oxley Act to determine the timing of filing reviews --issuers with the largest market capitalization. The Act also requires the Division to consider issuers that have filed material restatements to their financial results, those with significant volatility in their stock prices as compared to others, emerging companies with disparities in price-to-earning ratios and those with operations that may have a significant impact on a material sector of the economy.

A senior member of the Division advised that it was difficult to incorporate all of the risk factors, but that it considers all of them in making review decisions over a three-year cycle, rather than a one-year period. The Division has also finalized work with the Office of Economic Analysis to develop a methodology to identify companies with significant volatility in their stock prices. OIG recommended that the Division further incorporate all of the Act's risk factors into its timing of filing reviews, and issue appropriate guidance to the staff.

OIG found that the Division excluded certain companies from its first review cycle, such as those that were not required to file periodic reports after the first year or those that could deregister based on the small number of shareholders or limited asset size. The Division reviewed some of these companies during the first three-year cycle, but OIG said the Division should review all of the companies subject to the Act. If it excludes any companies from review, OIG said the Division should seek a formal legal opinion from the Office of the General Counsel to ensure the exclusion is permissible and then comply with that opinion.

OIG suggested that the Division adopt a program similar to one adopted by the Office of Compliance Inspections and Examinations in which OCIE continuously monitors developments at the largest investment advisory groups. OIG explained that the Division could assign staff to maintain continuous surveillance of developments at the largest companies through press releases, trading data and Forms 8-K to help identify material issues affecting those companies when the staff performs its preliminary reviews.

Since two-thirds of the issuers subject to review have a December 31 fiscal year-end, the influx of Forms 10-K in mid-March has created workload management problems for the staff. OIG found that companies with fiscal year-ends other than December 31 get financial statement or full reviews approximately 15% more often than the December 31 fiscal year-end companies. The cyclical nature of the workload can create pressure on the staff. However, the Division believes that the rule requiring the largest companies to file their Forms 10-K two weeks earlier and the newly established review procedures will help it to meet its review mandate.