May 10, 2006
Highlights from the SEC's May 10th Meeting on Section 404
Hey don't blame me. Lie down until the feeling goes away.
In any event, a star cast of panel members, SEC and PCAOB staffers and Chairman Cox covered five broad topics generally based on the experience of accelerated filers in Year 2 of their 404 activities, but also covering the concerns of smaller registrants (most of whom have not yet undertaken their first 404 audits).
Here is the brief overview of the key themes covered during the meeting:
Theme 1: Section 404 - Cost versus Benefit
It all depends on perspective on this one. Everyone wants to see improvements on the ratio of costs to benefits (more on where the cost reductions might come from later in this blog entry).
Accelerated filers generally felt that costs had leveled off and that benefits were significant and real. They are generally taking more of a risk-based approach and streamlining the number of controls.
Investors (i.e. Calpers) and rating services (i.e. Moody's) were more enthusiastic about the benefits and acknowledged that SOX had helped significantly with rebuilding investor confidence (although Sections 302/906 need lots of credit also) and is one of the causes (secondary) for lower cost of capital for well run businesses.
The audit firms highlighted recent studies indicating real cost reductions for 404 clients, as well as improved and integrated audit procedures at the audit firms that help to keep a lid on costs.
Panel members representing smaller firms were negative about the economic effects of SOX 404. They were united in supporting the recent recommendations made by the Advisory Committee on Small Business (click here to go the SEC website for their report) with respect to either an exemption or partial exemption from SOX 404 based on market cap/revenue criteria.
Theme 2: Improved Guidance
Two paths emerged in this area.
Auditors. The discussion was that the PCAOB should incorporate the May 16, 2005 guidance (see previous blog entry below: Hey! Have you seen my Guidance?) into Audit Standard 2. Ideally, this would not be done for 2006 reporting said many of the panel members, so as not to change existing 404 activities underway, but would kick-in during 2007 audits. This would provide a more consistent, and "friendly" approach to the external auditors testing of a registrant's controls, reliance on the work of others, and risk-based/top down methodology. As it is now, AS 2 brings out the real conservative in an engagement partner. Auditors remember what happened to Arthur Andersen, and many panel members felt that improved guidance to the auditors could streamline the process. Cleaning up the meaning of "material weakness" as described in AS2 seems like a good place to start. It is like debating the number of angels on the head of a pin.
Management. To-date management hasn't had lots of direction from the SEC in terms of practical guidance on internal controls. The default has been to ask the External Auditor, who then turns to AS 2 and then turns back to management and says, "What are you looking at?". Some fine commentary was made about management teams needing to take their own path with respect to internal control reviews. It is their business to run after all. Many panel members were looking for more practical guidance and examples from the SEC with respect to emphasis on entity-level controls versus process-level controls (top down/risk-based approach); cycling of testing to reduce costs; and, better direction on IT controls. It appeared during the discussion that Chairman Cox is looking to COSO for much of this guidance particularly for smaller companies where the compliance burden is greater given more limited resources.
Theme 3: Smaller Companies and Section 404
The meeting was supposed to focus on larger filers and their second year 404 experiences, but the voices of smaller filers were heard also. A CEO of a smaller bio-tech firm and a CFO of an electronics firms supported the recommendations of the Small Business Advisory Committee - mentioned above. Most other panel members want the issue of small business to go away and for the SEC to just get on with implementing 404 for smaller businesses with perhaps some basic streamlining. The aforementioned CFO (Alex Davern) woke the meeting up by declaring that he was annoyed by the "tremendous amount of polite discussion" during the meeting and that the SEC "deserves a failing grade for implementation of 404." He backed up his criticisms by reminding everyone that the SEC had predicted that the average cost for implementing SOX would be in the range of $90,000. Hey, what's a zero between friends! In the case of many small companies it could be a good portion of their income for the year.
Other panel members were less sympathetic. Nick Cyprus of COSO said "if you can't play the public game, don't take the public's money." Perhaps one audit committee member (J. Michael Cook) said it best when he said that the SEC needs to make a decision on the small business front ASAP and "It (404 for small business) needs to come off the front page."
We will be hearing more on this topic in the coming weeks as there remain about 5900 companies to file their first year 404 reports and the majority are waiting to see what the SEC recommends. If I were a small filer, I wouldn't bet on a reprieve. The current 404 timeline calls for smaller filers to hand in their reports beginning with those that have fiscal y/e after July 15, 2007.
Theme 4: Section 404 and the Competitiveness of U.S. Capital Markets
Much was made of the number of IPOs in the last 18 months that have not been launched on U.S. markets. The AIM market in London and the Hong Kong exchange were mentioned as being able to attract larger IPOs looking for cash - but not compliance. Some discussion was had about superior returns on U.S. markets, higher U.S. trading multiples, and foreign markets will follow U.S. trends, etc.
On another note, the CFO of NASDAQ was at the meeting today. He must have been amused about the discussion of London and AIM. NASDAQ just increased its ownership of the LSE to about 24%. Smart move. You get them leaving home and then coming back.
Theme 5: The Road Ahead
Chairman COX finished the meeting quickly saying that:
- 404 has produced significant benefits and costs
- Both the SEC and PCAOB will consider action based on the feedback received to-date
- The SEC will consider the Small Business Advisory Committee's recommendations
My guess about what the SEC will do. No major changes in the future. Investors generally like the legislation and that is what started the whole process in the first place. The learning curve will reduce costs and improve efficiencies. The PCAOB will knock some heads in the audit community and take down some names. A couple of tweaks, and small companies will be treated generally like big filers. Time to move on.
