April 07, 2006
No Exemptions for Smaller Public Companies?
Posted by Elizabeth Brown

I was surprised that, on the issue of whether small companies should be exempt from Section 404 of SOX, SEC Chairman Cox stated yesterday: "Our emphasis is on making 404 work and implementing it in a cost-effective and investor-protected way, rather than simply waiving it."  I am not certain what he gains by making this statement before he has even received the report of the SEC Advisory Committee on Smaller Public Companies.  If he doesn’t agree with the committee’s recommendations, which have been circulated for comment in a draft report, why didn’t he at least wait until he received the final report so that he can at least appear to have considered them before rejecting them? It seems unlikely that, in light of Chairman Cox’s comments, the Advisory Committee is going to radically rethink their recommendations between now and when Chairman Cox and the committee are scheduled to discuss their report on April 12th.

I sympathize with Chairman Cox’s position because if the SEC adopted the recommendations of the draft report, only a minority of publicly-held companies would be subject to the requirements of Section 404.  I am just surprised by the timing of his comments.

The draft report defines small businesses as those with a market capitalization of less than $787 million. Such businesses make up 80% of the publicly-traded companies, but only 6% of the total  US equity market capitalization.  The draft report recommends that new, scaled regulations be developed for small businesses and exemptive relief from the requirements of Section 404 for microcap companies with market capitalizations of $125 million or less. Microcap companies make up about 1% of the total US equity market capitalization but about 52% of the total publicly-traded companies. 

The draft report also includes a grab bag of recommendations that address a broader range of issues than those relevant primarily to smaller public companies.  As a result, the committee’s report looks a bit like Congressional legislation, which is stuff with rules or earmarks for certain constituencies that have little or no relevancy to the major objective of the bill.  For example, the committee recommends that the SEC:

  • Allow all reporting companies listed on a national securities exchange, NASDAQ or the OTC Bulletin Board to use Form S-3, if they have been reporting under the Exchange Act for at least one year and are current in their reporting at the time of the filing.
  • Develop a “safe harbor” protocol for accounting for transactions that would protect well-intentioned preparers from regulatory or legal action when the process is appropriately followed.
  • Consider additional guidance for all public companies with respect to materiality related to previously issued financial statements.
  • Implement a de minimis protection in the application of the SEC’s auditor independence rules.
  • Adopt a new private offering exemption from the registration requirements of the Securities Act that does not prohibit general solicitation and advertising for transactions with purchasers who do not need all the protections of the Securities Act’s registration requirements.

Regardless of the merits of these recommendations, I have serious reservations about having them slipped into a report, which is supposed to focus on the regulatory needs of smaller public companies. I think that some who may have an interest in the issues raised by those recommendations may not have commented on them because they were not aware of their existence since it may not have occurred to them that the committee was going to take such an expansive view of its mandate.

I also have some reservations about the last recommendation on creating a new private offering exemption which permits general solicitation and advertising. I wonder how effectively issuers will screen the actual purchasers of the securities in such offering to verify that they qualify as “eligible purchasers”.  Companies are going to receive considerably more requests to buy the securities from those who fail to qualify as eligible purchasers if they engage in general solicitation and advertising.  In the time crunch to get the deal closed, I wonder how thorough the companies and their investment bankers will be at screening out the eligible from the ineligible purchasers.  I also question the SEC’s ability to take effective action against companies that fail to adequately verify who is purchasing their securities.

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