In 2002, as a response to a number of major corporate and accounting scandals, the Public Company Accounting Reform and Investor Protection Act – more popularly known as the Sarbanes-Oxley Act – was enacted. Four years later, the Securities and Exchange Commission is still deliberating how to execute it.
The uncertainty surrounding Sarbanes-Oxley and its implementation with regard to smaller companies – when and how they will have to comply with Section 404, in particular – has lingered so long that small companies have struggled to understand if and how they need to comply.
This year has been one of much regulatory debate about the law; however, that deliberation is hopefully coming to an end. In the spring an SEC small company advisory panel recommended that the Commission exempt certain smaller public companies from Section 404 altogether.
The SEC Commissioners declined to do so but proposed to once again postpone the compliance deadline. They also signaled that the SEC would revise the auditing standards and issue further guidance for small companies.
Commissioner Chairman Christopher Cox has reportedly promised to offer this much-anticipated guidance by December 13, 2006. The key goal of any regulatory changes will be to reduce the costs associated with Section 404 compliance. Separately, there has been talk that Congress may revisit the law.
According to the most recently proposed compliance deadline, “non-accelerated filers” will be required to assess and report on their internal controls for fiscal years beginning after December 15, 2007. They will also have to begin providing an auditor’s attestation regarding these controls in the annual reports for fiscal years beginning after December, 15, 2008. The new standards and guidance will likely make meeting these requirements less burdensome. The changes are eagerly awaited by smaller public companies and their lawyers and accountants.
Section 404 calls for a series of internal controls, involving corporate managers and auditors, to prevent financial fraud. The Public Companies Accounting Oversight Board (PCAOB), a private non-profit company created by SOX to regulate accounting firms, drafted lengthy standards by which these internal controls would be audited. It is these standards that are now under scrutiny and will likely be revised.
Additionally, the Committee of Sponsoring Organizations of the Treadway Commission, a private group of experts that develops financial reporting guidance for public companies and their auditors, at the request of the SEC small company advisory committee, recently issued its latest guidance for smaller public companies on Section 404 internal controls requirements. The document is designed to help management with establishing and maintaining effective internal control over financial reporting and assessing the effectiveness of these controls.
Regardless of the changes soon to be announced by Chairman Cox, other challenges to the Sarbanes Oxley Act may continue to cloud the waters. Rep. Patrick McHenry (R-NC), a member of the House Financial Services Committee, has indicated there is interest in the House to reexamine Section 404’s requirements, and Rep. Ron Paul (R-TX) introduced a bill last year that would repeal the provision altogether.
In addition, a lawsuit that threatens the entire Sarbanes-Oxley regime has been filed by plaintiffs who claim that the establishment of the PCAOB violates the separation of powers principal under the Constitution. The plaintiffs, led by the Free Enterprise Fund, claim the PCAOB wields executive power but is “immune from presidential supervision or control” because its board members are appointed by the Commissioners.
It is highly possible that Congress will demure, and that the constitutional challenge will fail in the courts. If so, there is an argument to make for exempting specific industries from internal controls requirements. The biotechnology sector, in particular, has been hard hit by the law. Biotech executives have insisted that the overall compliance effort amounts to an unmerited distraction from their companies’ real mission – to become profitable and creative entities that produce products that improve, and sometimes save, peoples’ lives.
The Biotechnology Industry Organization has rightly advocated for change. While there is broad consensus that Section 404’s internal controls are valuable deterrents to fraud and, therefore, benefit investors, the costs of Section 404 – for individual companies, financial markets, and ultimately investors – outweigh the benefits on the whole. This is especially true in the life sciences industry, where companies are compelled to devote as much of their resources as possible to research and development.
Thus, while some uncertainty remains, it is not necessarily unwelcome. The delay in implementation has given regulators time to recalibrate this important statute. In the meantime, companies that are not yet required to comply with Sarbanes-Oxley will want to follow all regulatory developments before implementing any costly compliance efforts in the coming fiscal year.