SEC, GAO Quibble Over SOX Costs To Small Companies, Ignoring The Real Reasons 404 Isn't...

The question of whether Section 404 of the Sarbanes-Oxley Act is good or bad for small public companies deepened in the last few months as both the SEC and the GAO issued conflicting reports.

The SEC's Advisory Committee on Smaller Public Companies studied the issue for a year and released an

exposure draft on March 3 that, among other things, recommends exemption of small public companies from one or more aspects of Section 404 compliance in certain circumstances. A few weeks later, the SEC contradicted those recommendations and said that, "ultimately, all public companies will be required to comply with the internal control reporting requirements of Section 404."

Meanwhile, the GAO report says that compliance with 404 has been far more expensive for public companies than originally expected, but especially for companies with less than $75 million in market capitalization. The GAO report does not recommend an exemption, noting that regulators, investors, auditors and public companies themselves generally agree that SOX "has had a positive and significant impact on investor protection and confidence."

While both agencies focus on the expense of compliance, neither addresses the core differences between large and small public companies - and the real hurdles small public companies face in complying with 404. "Many of the [SEC] committee's findings appear aimed at explaining why it is so much more expensive for small companies to comply with Section 404, rather than why Section 404 ought not apply to them in the first place," writes Aegis J. Frumento, a partner in the New York office of Duane Morris, on Law.com.

Frumento's article is the best we have read to date in describing what constitutes small public companies, their role in our economy, and why they must be allowed more flexibility. We encourage you to read the entire article:

www.law.com/jsp/ihc/PubArticleFriendlyIHC.jsp?id=1146733529444.

"Because of [the] pivotal role that large companies occupy, they comprise an essential public trust ... The financial statements of large public companies should be highly reliable, and Section 404 will greatly contribute to that. But small public companies do not play the same institutional role as large ones. The risk to the economy from the collapse of a small public company is limited not only by its size, but also because the effects of such a collapse would not ripple very far out into the economy," Frumento writes.

"We know this because it happens all the time. Many small companies die a natural death each year without notice, but at the same time, many small companies are born each year to take their place. This natural cycle of renewal among small companies is the nation's great source of new ideas and new jobs. The development of new businesses should be nurtured, not hindered by regulations appropriate only to companies large enough to be small countries. Smaller public companies should be largely unfettered by regulation, because their crucial role in the economy is to be a focus of risk-taking, and regulation, which necessarily carries second-guessing and 'looking-over-the-shoulder' reticence in its wake, inhibits risk-taking."

But what about protection from fraud? Frumento states that investors in small public companies do not expect to be provided the same protections against fraud as investors in large companies. People invest in small public companies in the hope of a large reward. Yet high reward is just the positive face of risk, the obverse side being loss. In small public companies, "accounting irregularities have less to do with larceny than with simply buying time, staying alive until some event occurs - a big contract, a new approval, a sales benchmark - that allows the company to progress to real profitability," Frumento writes.

"If small public companies are to continue successfully in their singular role as the messy incubators of new business, they must have wide freedom to take all the risk they dare. That, more than how much money they have, is the essential difference between small and large public companies and ought to be more seriously considered in determining the extent to which Section 404 should apply to small companies," he notes.

At IPA, we concur.