In early 2006, the SEC's Advisory Committee on Smaller Public Companies issued an exposure draft of its "final report," which makes recommendations that would dramatically reduce the cost of Sarbanes-Oxley compliance for smaller issuers, including "scaling" SEC regulation for the smaller capitalization companies that represent over 80% of all public companies, but only 6% of total market capitalization, and a new private offering exemption. The Advisory Committee will send its report to SEC Chairman Cox on April 23, 2006.

This Update highlights the most significant recommendations for smaller public companies.

Background on the Advisory Committee on Smaller Public Companies

The Sarbanes-Oxley Act of 2002 was a shock to the system of many companies, particularly those with under $1 billion in market capitalization, in part, because of the "one size fits all" aspect of the Sarbanes-Oxley Section 404 assessment and reporting of internal controls for a financial reporting period. Moreover, in the absence of any other guidance, the COSO framework has become the de facto methodology for management to follow in complying with Section 404, even though as the Advisory Committee noted, the COSO framework was intended as an auditing standard. As the report describes, even the second year (after the more expensive initial year) of Section 404 compliance is expected to average $900,000 for issuers with market caps between $75 million and $700 million. The Committee concluded that Section 404 compliance costs not only represent much higher percentage of revenue for smaller public companies than for larger public companies but in fact create a competitive disadvantage for smaller public companies.

The Advisory Committee proposes a regulatory regime that imposes greater requirements on large companies and classifies public companies based on market capitalization and revenues as follows:

* Includes microcap and smallcap companies.

** The Advisory Committee recommends focusing on market capitalization rather than "public float" as is currently used by the SEC.

Advisory Committee's Primary Recommendations

The Advisory Committee report proposes significant relief for smallcap and microcap companies, including reducing or eliminating internal control over financial reporting requirements, reducing financial reporting and disclosure obligations, expanding access to Form S-3 and creating a new private offering exemption.

Relief From Sarbanes-Oxley Section 404 Internal Control Over Financial Reporting in Exchange for Corporate Governance Enhancements.  Sarbanes-Oxley Section 404 directed the SEC to implement rules that required an annual management assessment (the Section 404(a) assessment) of internal control over financial reporting and a third-party independent auditor attestation (the Section 404(b) report) reporting on and essentially auditing the internal control assessment by management. The Section 404(b) report is at the heart of the extraordinary expense of Sarbanes-Oxley for smaller public companies. The report proposes significant relief for smallcap and microcap companies.

• Certain Smallcap Companies and Microcap Would Get Relief From Section 404(b) External Auditor Involvement. The Advisory Committee recommends that, until a framework for assessing internal control over financial reporting that is more appropriate for smallcap companies is developed, the following smallcap and microcap companies would be exempt from the external auditor attestation requirement of Section 404(b):
  • smallcap companies with annual revenues less than $250 million, but greater than $10 million in annual product revenue; and
  • microcap companies with between $125 and $250 million in annual revenue.

These companies would remain subject to all other Section 404 requirements and to corporate governance requirements applicable to exchange listed companies, even if their securities are not listed on an exchange.

• Microcap Companies With Less Than $125 Million in Annual Revenue Would Get Full Relief From Section 404.Until a framework for assessing internal control over financial reporting that is more appropriate for microcap companies with less than $125 million in annual revenue (which for this purpose includes smallcap companies with annual product revenue less than $10 million) is developed, these companies could elect to be fully exempted from Section 404, provided that they strengthen their corporate governance by making additional disclosure on internal control over financial reporting, adhering to certain audit committee standards and adopting and disclosing a code of ethics under Item 406 of Regulation S-K of the Exchange Act applicable to all directors, officers and employees.
• All Smallcap and Microcap Companies Must Maintain Internal Controls, CEO and CFO Certifications and Make Related Disclosures. These companies would continue to be required to maintain a system of internal controls, provide CEO and CFO certifications, have their financials independently audited, report on internal control over financial reporting and disclose material weaknesses.

Reduced Disclosure and Reporting Obligations. In addition to the relief from Section 404 internal control over financial reporting requirements, the Advisory Committee also proposes scaling back disclosure obligations for both microcap and smallcap companies. Microcap Companies.

• Microcap companies could elect to use scaled disclosure reporting by filing their Exchange Act disclosure documents under a new system that substantially mirrors the Regulation S-B regime currently in effect for small business issuers. Under current rules, only companies with less than $25 million in float and revenues may file under Regulation S-B.

Smaller Public Companies. Smaller public companies (both microcap and smallcap) would be able to use scaled regulation for financial statements. Only two years of balance sheets, income statements and cash flow statements would be required in annual reports and registration statements. This would extend the relaxed financial statement requirements of Regulation S-B small business issuers to all newly defined smaller public companies, except that two years of balance sheets would be required rather than the single year currently required.

Expanded Form S-3 Eligibility for Smaller Issuers

All reporting companies that have been reporting for over one year and are current in their filings would be eligible to use Form S-3 for primary or secondary offerings, regardless of market capitalization or public float, including those issuers with stock traded on the OTCBB. However, smaller public companies would not enjoy automatic effectiveness of such registration statements. Currently, only issuers with stock listed on a national securities exchange or traded in the Nasdaq Stock Market which have public float of at least $75 million and which have made timely filings of Exchange Act reports are permitted to file a primary offering on Form S-3. This is a significant change for mostly microcap companies that previously had to file more expensive and time consuming Form S-1 or SB-2 registration statements to raise capital and for companies that may have failed to file timely a Form 8-K.

New Private Offering Exemption

The Advisory Committee proposes adopting of a new private offering exemption that focuses on the character of the investor, rather than the method of offering. The exemption would not prohibit general solicitation and advertising for transactions with purchasers who do not need all the protections of the Securities Act and would relax the general "test the waters" model of Rule 254 under that Act. Under this proposal, sales would be permissible to qualified purchasers (i.e., accredited investors), even if general solicitation and advertising methods were employed.

Conclusion

We expect that the SEC will accept and adopt some, but not all, of the Advisory Committee's suggestions, including some form of relief from Section 404 internal controls reporting requirements. It is likely to be months before the SEC proposes rule changes, and the next sense of the SEC's direction could come at the SEC public hearing to address the report on April 20, 2006. However, according to newspaper accounts of a speech in early April 2006, SEC Chairman Cox indicated that in his view small companies should not necessarily expect the SEC to completely exempt them from the internal controls provisions of Sarbanes-Oxley.

Additional Information

You can find a copy of the full text of the Advisory Committee's draft final report at http://www.sec.gov/rules/other/33-8666.pdf. You can find discussion of other recent SEC activities and other topics of interest on our website.