[House Hearing, 110 Congress]
[From the U.S. Government Publishing Office]
FULL COMMITTEE HEARING ON SARBANES-OXLEY
SECTION 404: WILL THE SEC'S AND PCAOB'S
NEW STANDARDS LOWER COMPLIANCE COSTS
FOR SMALL COMPANIES?
=======================================================================
COMMITTEE ON SMALL BUSINESS
UNITED STATES HOUSE OF REPRESENTATIVES
ONE HUNDRED TENTH CONGRESS
FIRST SESSION
__________
JUNE 5, 2007
__________
Serial Number 110-26
__________
Printed for the use of the Committee on Small Business
Available via the World Wide Web: http://www.access.gpo.gov/congress/
house
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HOUSE COMMITTEE ON SMALL BUSINESS
NYDIA M. VELAZQUEZ, New York, Chairwoman
WILLIAM JEFFERSON, Louisiana STEVE CHABOT, Ohio, Ranking Member
HEATH SHULER, North Carolina ROSCOE BARTLETT, Maryland
CHARLIE GONZALEZ, Texas SAM GRAVES, Missouri
RICK LARSEN, Washington TODD AKIN, Missouri
RAUL GRIJALVA, Arizona BILL SHUSTER, Pennsylvania
MICHAEL MICHAUD, Maine MARILYN MUSGRAVE, Colorado
MELISSA BEAN, Illinois STEVE KING, Iowa
HENRY CUELLAR, Texas JEFF FORTENBERRY, Nebraska
DAN LIPINSKI, Illinois LYNN WESTMORELAND, Georgia
GWEN MOORE, Wisconsin LOUIE GOHMERT, Texas
JASON ALTMIRE, Pennsylvania DEAN HELLER, Nevada
BRUCE BRALEY, Iowa DAVID DAVIS, Tennessee
YVETTE CLARKE, New York MARY FALLIN, Oklahoma
BRAD ELLSWORTH, Indiana VERN BUCHANAN, Florida
HANK JOHNSON, Georgia JIM JORDAN, Ohio
JOE SESTAK, Pennsylvania
Michael Day, Majority Staff Director
Adam Minehardt, Deputy Staff Director
Tim Slattery, Chief Counsel
Kevin Fitzpatrick, Minority Staff Director
______
STANDING SUBCOMMITTEES
Subcommittee on Finance and Tax
MELISSA BEAN, Illinois, Chairwoman
RAUL GRIJALVA, Arizona DEAN HELLER, Nevada, Ranking
MICHAEL MICHAUD, Maine BILL SHUSTER, Pennsylvania
BRAD ELLSWORTH, Indiana STEVE KING, Iowa
HANK JOHNSON, Georgia VERN BUCHANAN, Florida
JOE SESTAK, Pennsylvania JIM JORDAN, Ohio
______
Subcommittee on Contracting and Technology
BRUCE BRALEY, IOWA, Chairman
WILLIAM JEFFERSON, Louisiana DAVID DAVIS, Tennessee, Ranking
HENRY CUELLAR, Texas ROSCOE BARTLETT, Maryland
GWEN MOORE, Wisconsin SAM GRAVES, Missouri
YVETTE CLARKE, New York TODD AKIN, Missouri
JOE SESTAK, Pennsylvania MARY FALLIN, Oklahoma
.........................................................
(ii)
?
Subcommittee on Regulations, Health Care and Trade
CHARLES GONZALEZ, Texas, Chairman
WILLIAM JEFFERSON, Louisiana LYNN WESTMORELAND, Georgia,
RICK LARSEN, Washington Ranking
DAN LIPINSKI, Illinois BILL SHUSTER, Pennsylvania
MELISSA BEAN, Illinois STEVE KING, Iowa
GWEN MOORE, Wisconsin MARILYN MUSGRAVE, Colorado
JASON ALTMIRE, Pennsylvania MARY FALLIN, Oklahoma
JOE SESTAK, Pennsylvania VERN BUCHANAN, Florida
JIM JORDAN, Ohio
______
Subcommittee on Urban and Rural Entrepreneurship
HEATH SHULER, North Carolina, Chairman
RICK LARSEN, Washington JEFF FORTENBERRY, Nebraska,
MICHAEL MICHAUD, Maine Ranking
GWEN MOORE, Wisconsin ROSCOE BARTLETT, Maryland
YVETTE CLARKE, New York MARILYN MUSGRAVE, Colorado
BRAD ELLSWORTH, Indiana DEAN HELLER, Nevada
HANK JOHNSON, Georgia DAVID DAVIS, Tennessee
______
Subcommittee on Investigations and Oversight
JASON ALTMIRE, PENNSYLVANIA, Chairman
CHARLIE GONZALEZ, Texas LOUIE GOHMERT, Texas, Ranking
RAUL GRIJALVA, Arizona LYNN WESTMORELAND, Georgia
(iii)
?
C O N T E N T S
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OPENING STATEMENTS
Page
Velazquez, Hon. Nydia M.......................................... 1
Chabot, Hon. Steve............................................... 2
WITNESSES
PANEL I
Cox, Hon. Christopher, Chairman, Securities and Exchange
Commission..................................................... 4
Olson, Mark W., Public Company Accounting Oversight Board........ 7
PANEL II
Greenwood, Hon. James C., Biotechnology Industry Organization.... 21
Casey-Landry, Diane, America's Community Bankers................. 23
Scott, Hal, Harvard Law School................................... 25
Heesen, Mark G., National Venture Capital Association............ 28
Hirschmann, David, U.S. Chamber of Commerce...................... 30
Schmalzl, Richard, Graydon Head & Ritchey LLP.................... 32
APPENDIX
Prepared Statements:
Velazquez, Hon. Nydia M.......................................... 45
Chabot, Hon. Steve............................................... 47
Cox, Hon. Christopher, Chairman, Securities and Exchange
Commission..................................................... 49
Olson, Mark W., Public Company Accounting Oversight Board........ 56
Greenwood, Hon. James C., Biotechnology Industry Organization.... 75
Casey-Landry, Diane, America's Community Bankers................. 84
Scott, Hal, Harvard Law School................................... 93
Heesen, Mark G., National Venture Capital Association............ 99
Hirschmann, David, U.S. Chamber of Commerce...................... 104
Schmalzl, Richard, Graydon Head & Ritchey LLP.................... 111
Statements for the Record:
Independent Community Bankers of America......................... 119
Institute of Management Accountants.............................. 126
(v)
FULL COMITTEE HEARING ON
SARBANES-OXLEY SECTION 404:
WILL THE SEC'S AND PCAOB'S
NEW STANDARDS LOWER
COMPLIANCE COSTS FOR SMALL COMPANIES?
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TUESDAY, JUNE 5, 2007
U.S. House of Representatives,
Committee on Small Business,
Washington, DC.
The Committee met, pursuant to call, at 2:10 p.m., in Room
2360 Rayburn House Office Building,Hon. Nydia M. Velazquez
[Chairwoman of the Committee] presiding.
Present: Representatives Velazquez, Larsen, Clarke,
Ellsworth, and Chabot.
OPENING STATEMENT OF CHAIRWOMAN VELAZQUEZ
Chairwoman Velazquez. I call this hearing to order.
This afternoon the Committee will examine implementation of
Section 404 of the Sarbanes-Oxley Act and consider whether the
new standards that the SEC and PCAOB approved last month will
lower compliance costs for smaller companies.
Small firms continue to be supportive of the intent of the
Sarbanes-Oxley Act and many have benefited from the stronger
corporate government's culture that it encourages. What we
continue to find is that many aspects of complying with SOX,
and particularly those associated with Section 404, are
disproportionately impacting small companies. These continue to
make me believe that these new regulations should be delayed.
This additional time is especially important for smaller
companies which often operate with limited human and financial
resources and may be unreasonably burdened by these high costs.
We may jeopardize some of our country's most innovative
endeavors if we fail to adequately balance investor protection
with the associated regulatory burden.
Last month new management guidance and an auditing standard
for Section 404 were approved. The result of nearly 2 years of
work, this new standard seeks to make Sarbanes-Oxley compliance
more efficient and cost effective for companies of all sizes.
While I am encouraged by this, I am concerned about the
proposed timeline under which small firms will have to comply
with the new regulations.
An important step to mitigating this will be, prior to the
SEC's approval of the auditing standard, the Commission should
undertake a full analysis as prescribed by Section 603 of the
Regulatory Flexibility Act. This will ensure that this
regulation is appropriately tailored.
Earlier this year Ranking Member Chabot and I wrote to
Chairmen Cox and Olson and expressed our concern that the
proposed implementation timeline was inadequate to assess its
effectiveness. Postponing the December 2007 and December 2008
deadlines by at least 1 year would allow for the new standards
to be tested and for evidence to be collected that could
confirm that the new standards do, in fact, lower costs for
small firms.
Small businesses are significant sources of research and
development, job creation and innovation in our economy. It is
critical that the SEC and PCAOB work to ensure that SOX 404 is
implemented in a way that contributes to increased investor
confidence, but that also does not hamper America's
competitiveness. Postponing the compliance deadlines for at
least an additional year would allow us to make this
determination.
A delay will also provide training for small companies and
auditing firms. It will also permit the PCAOB's efficiency
inspectors to assess whether audit firms are implementing the
new standards in the manner intended. At a minimum these steps
will help ensure a more effective implementation of these new
standards and recognize the unique situation that many
companies find themselves in.
These new standards come at a time when small businesses
are already spending 45 percent more than larger firms on
regulatory compliance. To ensure that these burdens become more
manageable we should not be piling new regulations on until
they have been thoroughly reviewed. Today's hearing will help
us accomplish this, and by doing so, it will demonstrate that a
delay is necessary to better balance the cost and benefits of
these new standards.
I would like to take this opportunity to welcome Chairman
Cox and Chairman Olson and also to thank the members from the
second panel that are traveling from across the country to be
here to shed some insight regarding the implementation of
Section 404 on small firms.
Now I recognize Mr. Chabot for his opening statement.
OPENING STATEMENT OF MR. CHABOT
Mr. Chabot. Thank you, Madam Chairwoman, and thank you for
holding this hearing on Section 404 of the Sarbanes-Oxley Act
and its impact on small businesses.
The Sarbanes-Oxley Act has been described as the most
important and far-reaching securities legislation since the
Securities Act of 1933 and the Securities Exchange Act of 1934,
which were passed following the stock market crash back in
1929. Signed into law in 2002 in response to the bankruptcy of
Enron Corporation, the WorldCom scandal and other corporate
failures, the Sarbanes-Oxley Act established the Public Company
Accounting Oversight Board, a private-sector, nonprofit
organization that oversees public company auditors and enacts
auditing standards. The act also restricts accounting firms
from performing a number of other services for companies which
they audit and requires new disclosures for public companies
and officers and directors.
While the act has generally been viewed as necessary to
restore public and investor confidence in our capital markets
and improve the reliability and transparency of commercial
financial reports, concerns have been raised about the burden
and cost of compliance for small- and medium-sized companies.
One of the most controversial provisions, Section 404,
management assessment of internal controls, requires management
and auditors to assess internal controls over financial
reporting and requires external auditors to report on
management's assessment and certify to the effectiveness of
internal controls.
The Securities and Exchange Commission greatly
underestimated the amount that it would cost small businesses
to comply with Section 404. According to an April 2006
Government Accountability Office study, small businesses expend
a disproportionately greater amount of time and money as a
percentage of revenues compliant with Sarbanes-Oxley than large
public companies. Firms with $1 billion or more spend 13 cents
per $100 in revenue for audit fees to comply with Sarbanes-
Oxley regulations, while small businesses spend more than $1
per $100.
It is generally agreed that Sarbanes-Oxley has had a
positive effect on investor protection and confidence, but its
burden on small business has not only affected their bottom
line, but also their competitiveness in our global academy.
GAO found that small businesses used resources for
Sarbanes-Oxley compliance rather than for other business
activities. Recently, the Kauffman-RAND Center for the Study of
Small Business and Regulation said that Sarbanes-Oxley caused
small firms to exit the public capital market. Last year the
Securities and Exchange Commission announced that it would
delay the application of Section 404 to the smallest companies
until later in 2007.
Earlier this year the chairwoman and I together urged the
SEC to delay implementation of the new internal control
standards to allow small businesses additional time to comply.
On May 23, 2007, this year, the SEC announced it would not
allow such an extension. At its May 23, 2007, meeting the SEC
adopted rules designed to reduce costs for compliance with
Section 404 for all businesses. In addition, the Commission
adopted proposed rules examining the general disclosure
requirements for small companies wanting to go public. This
represents an excellent opportunity for the Commission to
examine the cumulative impact of its rules on small companies
and reduce those while still striving to maintain investor
confidence.
Madam Chairwoman, I commend you for holding this hearing on
Section 404 compliance. I want to note that in addition to our
panel of experts we have with us an attorney from Cincinnati,
my district, who has real-world experience in helping small
public company clients to deal with the challenges of Section
404 compliance.
I look forward to this hearing from each of our witnesses.
We want to thank them in advance for their testimony.
And I also want to welcome to Washington, D.C., my brother,
my younger brother, 10 years younger, Dave, and his wife Ellen
who are with us today with their four beautiful children and
they are in the back there. How about the whole family stand up
back there. Kids, come on and stand up. We don't have visitors
up here all that often. There are a whole bunch of them there.
So those are Chabots back there. And that's how we pronounce
it, even though it gets pronounced all different ways up here.
Chairwoman Velazquez. And welcome to my club.
Mr. Chabot. Exactly. That's right. I yield back my time.
Chairwoman Velazquez. Thank you.
Our first witness is our former colleague, the Honorable
Christopher Cox. He is the 28th chairman of the Securities and
Exchange Commission. He was appointed by President Bush on June
2, 2005, and unanimously confirmed by the Senate on July 29,
2005. During his tenure at the SEC Chairman Cox has brought
groundbreaking cases against a variety of market abuses,
including hedge fund insider trading, stock options back-dating
and securities scams on the Internet.
Prior to joining the Securities and Exchange Commission,
Chairman Cox served for 17 years in Congress where he held a
number of positions of leadership in the U.S. House of
Representatives.
Honorable Christopher Cox, you are welcome and we are very
grateful that you are here with us today.
STATEMENT OF THE HONORABLE CHRISTOPHER COX, CHAIRMAN,
SECURITIES AND EXCHANGE COMMISSION
Mr. Cox. Madam Chairwoman, thank you very much for your
gracious introduction to my colleagues. I am very, very honored
with the opportunity to be here, along with Chairman Olson, to
talk about this very important subject.
The Committee has a very important charge, and we share a
good portion of what you are responsible for within our sphere
at the Securities and Exchange Commission. We all have a
responsibility to the millions of small businesses in America
and, in that way, to our economy.
For our part, the SEC is charged by statute with the
protection of investors, fostering efficient markets and the
promotion of capital formation. Small business needs all of
these in order to survive. So like every member of this
Committee, the SEC is completely committed to fostering a
climate of entrepreneurship. That climate is necessary to help
promote small business growth, and it is necessary to the
creation of the many jobs and goods and services in our country
that are produced by small business,
Today, as every member of this Committee well knows, there
are over 6,000 public companies that are smaller businesses
that still aren't required to comply with Section 404 of the
Sarbanes-Oxley Act of 2002. Generally that is every public
company with securities registered with the Commission if it
has less than $75 million in public equity.
The Commission has, as you have noted, delayed Section 404
compliance for smaller companies precisely because of the
disproportionately high costs that they face compared to larger
companies. Our experience in the first 3 years of compliance
after the enactment of SOX told us that the way that 404 was
being implemented was too expensive for everyone. And imposing
that system on the smallest companies would impose unacceptably
high costs from the standpoint of the companies' investors who
would have to pay the bills.
So the Commission and the Public Company Accounting
Oversight Board set out to address the unique concerns of small
business; and as you are aware, the Commission has carefully
phased in application to the 404 requirements. We have
repeatedly deferred 404 compliance for smaller companies with
the very positive result of this determination to phase in 404
for smaller companies being that we and they have had and will
have the opportunity to field test the requirements first.
Now we are using what we have learned thus far and we will
continue to use what we learn to lessen the burden for smaller
companies that eventually will have to comply with Section 404.
We have little doubt that the SEC's new guidance, specifically
for management, and the PCAOB's new standard, which Chairman
Olson will talk about in a little more detail in a moment, will
be of significant help to smaller companies when, beginning
with their SEC annual filings in 2009, they eventually comply
with the audit provisions of Section 404. In the meantime, for
their filings in 2008, they will have to comply only with the
management assessment portion of Section 404.
For this purpose, the SEC's new guidance should be
especially helpful. It is written in plain English. It suggests
that certifying officers at smaller companies ask themselves
two basic questions: First, do my employees understand what
they need to do to prepare reliable financial statements; and
second, what information do I need to be sure that they have
done those things.
The answers to these questions needn't be complicated or
costly. And certainly our guidance won't make them so. In fact,
the guidance clearly highlights the areas where cost-effective
implementation has been a challenge for small companies in the
past so that these pitfalls can be avoided, and it explains how
a small company might approach 404 differently than a large
company. None of this should be unduly difficult for most
companies, and it certainly does not require the 404 audit that
has had smaller companies so concerned about cost.
As we meet here in mid-2007, the requirement of an internal
control audit under Section 404 won't apply to smaller public
companies with calendar and fiscal years until their filings in
the spring of 2009, almost 2 years from now. In the meantime,
those smaller companies can begin to get ready for full SOX 404
compliance by undertaking their own assessments of internal
controls beginning with their SEC reports in 2008.
So, in response to suggestions that the Commission should
extend 404 compliance for another year, the answer is that
smaller companies won't be required to come into full
compliance with SOX 404 until their report is due in March
2009, almost 2 years from now. This schedule gives smaller
companies the benefit of doing an initial internal assessment
of their controls without the added burden and cost arising
from an external audit. We fully expect that by the end of 2008
management's familiarity with the 404 process and its
documentation of internal controls will make it easier and less
expensive to do an external audit than it would have been under
the previous system.
Madam Chairwoman, the focus of this hearing is on whether
the SEC's new guidance for management and the PCAOB's new
standard for auditors will lower compliance costs for small
companies. The answer to that question is "yes." we expect the
unduly high costs of implementing Section 404 of the act under
the previous auditing standard will come down. They should come
down because now a company will be able to focus on the areas
that present the greatest risk of material misstatements in the
financials. That is what the law has always intended we be
focused on. It is always what investors care about; it is what
is important for achieving reliable financial reporting.
Compliance costs should come down because the new SEC
guidance that has been developed specifically for management
will allow each small business to exercise significant judgment
in designing an evaluation that is tailored to its individual
circumstances. Unlike external auditors, management in a
smaller company tend to work with its internal controls on a
daily basis. They have a great deal of knowledge about how
their firm operates. Our new guidance allows management to make
use of that knowledge, which should lead to a much more
efficient assessment process.
Compliance costs should also come down for the minority of
smaller public companies that had already complied with Section
404 under the old auditing standard. In recognition of the fact
that many of those companies have already invested considerable
resources in the design and the implementation of their
processes the Commission's guidance does not disrupt or require
any changes to what they are now doing.
While these smaller companies should benefit from the top-
down, risk-based, materially focused and scalable nature of
both the SEC's new guidance and the PCAOB's new auditing
standard, they should not have to expend new resources to do
so.
The goal of our collective efforts in this area, the SEC
and the PCAOB, is to implement Section 404 just as Congress
intended in the most efficient and effective way to meet our
objectives of investor protection, well functioning financial
markets and healthy capital formation by companies of all
sizes. We won't forget the failures that led to the passage of
the Sarbanes-Oxley Act in the first place, and we won't forget
that for small business to continue to prosper, both strong
investor protection and healthy capital formation must go hand
in hand.
These past few weeks have witnessed several positive steps
for small business at the SEC. Not only are we approaching the
finish line in our work to rationalize and improve the 404
process for smaller companies, but also we are tackling several
other issues of importance to our Nation's small businesses.
The most important of these is our effort to modernize and
improve capital raising for small business and to simplify SEC
reporting for small business. Many of these proposals would
implement key recommendations made by the Commission's Advisory
Committee on Smaller Public Companies.
Our concerns for small business go hand in hand with our
responsibility to protect investors. It is, after all,
investors who are injured and whose money is lost when the
small businesses in which they invest can't get affordable
access to new capital.
Madam Chairwoman, the SEC takes extremely seriously and
equally seriously each element of its tripartite mission. The
404 reforms, the capital-raising improvements that I just
mentioned and the reporting simplifications that we proposed to
benefit small business will, I am certain, help our country to
accomplish all three of these objectives.
Thank you again for the opportunity to speak on behalf of
the Commission, and of course I will be happy to answer your
questions.
Chairwoman Velazquez. Thank you Chairman Cox.
[The prepared statement of Mr. Cox may be found on page 49
of the Appendix.]
Chairwoman Velazquez. Our next witness is the Honorable
Mark Olson, who became chairman of the Public Company
Accounting Oversight Board on July 3, 2006. The PCAOB is a
private-sector, nonprofit corporation created by the Sarbanes-
Oxley Act of 2002 to oversee the auditors of public companies.
Prior to his appointment to the PCAOB board, Mr. Olson
served as a member of the Federal Reserve Board of Governors
and the Federal Open Market Committee. Before becoming a member
of the Federal Reserve Board, Mr. Olson held a number of
positions in the banking industry and was a partner with the
accounting firm, Ernst & Young.
Welcome, sir.
STATEMENT OF MARK W OLSON, CHAIRMAN, PUBLIC COMPANY ACCOUNTING
OVERSIGHT BOARD
Mr. Olson. Thank you very much. Madam Chairwoman Velazquez
and Ranking Member Chabot and members of the Committee, I am
delighted to be here today on behalf of the PCAOB. I am pleased
to be here with Chairman Cox, whom we have worked closely with
in this effort. The full text of my statement has been
submitted for the record, but I would like to make a couple of
summary comments and then be happy to answer any additional
questions that you might have.
I think at the outset it is important to remember--and I
know that all the members of the Committee do, but just as a
reminder--the 404 does not apply to all small businesses.
Section 404 applies to small businesses that choose to access
the U.S. capital markets; and that is a critical distinction,
because in exchange for your willingness to access the U.S.
capital markets, the management has been asked to accept a
heightened level of responsibility for the internal controls
over financial reporting.
That new responsibility, I think, helps provide stability
to the U.S. capital markets, but very importantly, it helps
build confidence in markets for the average investor. And that
is critically important because, as all of the members know, I
am sure, over half of U.S. households are now equity holders in
one form or another. In my mind, it is the essence of Sarbanes-
Oxley 404.
And I agree with Ranking Member Chabot when he says that is
probably the most significant legislation since the 1933 and
the 1934 Acts. But what it does is provide a level of
confidence that wasn't there before. But it is the third time
Congress has chosen to act and to act in a way that has
mandated internal controls over financial reporting. The first
was the Foreign Corrupt Practices Act and the second was in
FDICIA.
That said, we are working in a number of ways to
specifically focus on small business at the PCAOB in two
particular ways that I would like to highlight: first of all,
the fact that most of the registrants that registered with us,
the accounting firms, the auditing firms that registered with
us, are themselves small businesses.
I was surprised, when I looked closely at the statistics
regarding the PCAOB, that there are 1,700 accounting firms,
auditing firms, that have registered with the PCAOB, which
means that there are 1,700 firms that either now do or wish to
audit companies that are traded in the U.S. public markets. Of
those 1,700, 1,000 them are in the U.S., and of those 1,000,
only 150 have 5 or more publicly traded companies that they
audit. So 800-some--850 roughly--firms that register with us
either audit fewer than 5 or are not listed currently as the
auditor of any, but they choose to. And that number is growing
so that there is an increasing number of small firms around the
country. There are 129, for example, in New York alone and 1934
in Ohio alone that fit this category.
Also we have been working very hard to make sure that as we
get closer to the implementation for the small, nonaccelerated
filers that the small firms can be ready; and let me give you a
couple of examples of what we are doing.
First of all, we are hosting seminars around the country
for the small accounting firms and, in some cases, members of
audit committees. We have done those with 21 different firms in
14 different markets, that have been attended by over 2,000
people, where we have acquainted them with the PCAOB; but more
importantly, helped them understand and recognize the extent to
which the responsibility will be for auditing under Section
404, particularly for the nonaccelerated filers.
Point number two is that we are working with a group of 12
accounting firms now to specifically focus on developing
guidance for the smaller firms, so that as they are getting
ready to audit on 404, we can help them identify how they would
identify the key controls and how they would identify a control
environment that would be more applicable to a small firm, so
that it can reach the point that you mentioned, Congresswoman,
when you talked about the disproportionate burden that would
fall to small business if we don't aggressively address that
point. That is precisely the effort that is under way.
Point number three, Chairman Cox indicated, which we have
just passed and sent to the SEC for their review, the AS 5, the
scalability portion of that adjusted standard, specifically
focuses on ways that we can be scalable to address the smaller
and less complex businesses.
And I think, very importantly, as Chairman Cox mentioned,
the fact that we are now linking the AS 5 with the management
guidance that have been produced by the SEC will in fact answer
the question that you asked at the outset, which is, will the
revisions bring costs down. And I agree with the chairman,
there is no reason why those costs should not come down because
of the fact that we have made the standard that much more
scalable and that we have reduced the wording that would have
resulted in unnecessary procedures being made by the external
auditor.
As to the delay, the bill was passed, as I said, in 2002.
It has now delayed full implementation until 2009. To delay it
a year, until 2010, would mean that full implementation would
have taken the equivalent of four terms in the House of
Representatives. And I think, in our judgment as we have looked
at the manner in which we have delayed, and particularly what
the SEC has done in staging the dates of compliance, it seems
to me that there is adequate time built into it now for the
firms to be ready.
[The prepared statement of Mr. Olson may be found on page
56 of the Appendix.]
Chairwoman Velazquez. Thank you, sir.
Chairwoman Velazquez. Chairman Cox, I know that you will
not be able to stay to hear the testimony of the second panel
of witnesses this afternoon, so I want to pose to you the
question that I expect will be central to the second panel of
witnesses.
Will you support further postponing SOX 404 compliance
dates for smaller public companies?
Mr. Cox. Chairwoman, I think because this has been the
subject of my formal testimony and also Chairman Olson's, that
I should ask you with respect to the upcoming panel--by the way
I want you to know that the SEC will be here in full force to
listen to that testimony--
Chairwoman Velazquez. I understand.
Mr. Cox. --but to make sure that we are addressing
ourselves to the same question, are you focused on the 404
audit?
Chairwoman Velazquez. Yes.
Mr. Cox. Because I think what we have taken pains to
explain is that while there will be required compliance with
404(a)--404 is very short, it has part (a) and part (b), and
404(a) compliance will kick in for smaller companies in 2008
and 404(b) won't kick in until filings in 2009.
Chairwoman Velazquez. And I will have a question for you in
terms of those dates.
Mr. Cox. Right.
And so is what you are asking, are we thinking about 2010?
Chairwoman Velazquez. Well, Mr. Chairman, in reading the
testimonies that will be presented here this afternoon and in
the meetings that we have had with the sectors that will be
impacted by this, it seems that small companies do not feel
that because they will have until 2009 to comply with the
PCAOB--that the problem is that in order to comply with the SEC
in 2008, they will have to incur expenses that have to relate
to 2009.
And I am going to ask you this question so that you can see
why there is so much concern, not about the fact that you are
coming here and saying, "But they will not have to comply with
those guidelines until 2009," but in order to comply, for the
2008 reports that they have to present to SEC in 2008, they
will have to incur expenses that are supposed to be related to
the reports that they have to submit to the PCAOB in 2009.
In your testimony--
Mr. Cox. Madam Chairwoman--
Chairwoman Velazquez. I am going to try to explain in this
question.
In your testimony you highlight that a further delay in the
compliance date is at this point unnecessary. Explaining this
point, you emphasize that small companies will not have to come
into full compliance until March 2009. This reasoning assumes,
however, that management is willing to sign annual reports for
fiscal years ending on or after December 15, 2007, without an
outside auditor's review.
Because of reasonable concerns about potential liability
associated with information included in such reports, I expect
that the December 2007 deadline is likely to force a number of
smaller public companies to implement both the SEC's and
PCAOB's new standard during the second half of 2007.
Do you agree that this is a likely consequence of the SEC's
existing SOX compliance timeline for smaller firms?
Mr. Cox. No, Madam Chairwoman, but I think it is very
useful to have that question asked publicly and answered
publicly.
That is not at all the intention of what the SEC is doing,
nor is it the intention of what the PCAOB is doing, I think
fair to say, although I will let Chairman Olson comment for the
PCAOB.
What we are seeking to do is completely the opposite, and
that is to stage compliance for smaller companies. There is
absolutely no question, given all of the evidence that we have
received--and as you know, we have been very carefully
consulting with small businesses across America in a variety of
formal ways. All of the evidence that we have received suggests
that the costs that are of particular concern in Section 404
compliance relate to the 404 audit. As a result, by letting
management for the first time have guidance directly from the
SEC on what it should do as a company--not relying on its
auditors, but what it should do to assess its own internal
controls--and to be sure that its style is scaled for smaller
companies so that their approach needn't be the same as it is
for a large company, we think that they will have a very
different opportunity than they would have had if they had to
comply with what I am going to call "old 404" and "old AS 2."
after they have a year's experience with that process and after
they get to watch other larger companies work with the new
standard, AS 5, then and only then would they be required to
file, themselves, financial reports that include as part of the
integrated audit a 404 audit.
Chairwoman Velazquez. Mr. Olson, you don't see the concern
coming from small companies regarding compliance with PCAOB's
and expenses that they will have to incur in order to comply
with SEC by the year 2008?
Mr. Olson. Well, we do see the concern. I think a number of
things have been done to alleviate--I think the concern and the
linkage between the management guidance that the SEC has just
come out with on their 404(a) and the new audit standard that
we have done on 404(b) help address that issue.
I think it is very important because the management
guidance was designed as guidance for management, obviously.
And what that guidance does is to outline for the management of
a company that is already very much aware of the internal
control environment that they have. And for the companies that
already have good internal controls, the management guidance
will still be that important guidance; but for companies that
have postponed taking a careful look at their internal control
environment, this will tell them what management is to do.
And as you indicated, they will be required to file that a
year from now. Then the external auditor, which is the standard
that we have provided--the external auditor will then have
until the following year to have completed the audit.
Part of what was not addressed--and I think that this is
part of the concern--is that in the AS 2, the AS 2 guidelines
which were very specific were sometimes taken as the de facto
standard for management. What the SEC has done now is to give
them a much more manageable guideline that I think will help
address that concern.
Chairwoman Velazquez. Well, let me ask you both, didn't you
think that small companies will seek an outside audit opinion
in order to sign off on the submissions, as requested by the
SEC?
Mr. Cox. Of course they will have audited financials.
Chairwoman Velazquez. But you said that, no, the costs will
be lower since they don't have to comply until 2009. But in
order to comply with the report that they have to send to you,
they will have to seek an outside auditor's opinion.
Mr. Cox. But that audit, just to be clear, if we are
talking about 2007 and 2008, that audit will not be a 404 audit
of the company's internal controls, but rather it will be the
financial audit that is necessary for all public companies and
has always been necessary for smaller public companies.
Chairwoman Velazquez. Let me ask you, in your testimony you
confirm that the new standards will reduce SOX 404 compliance
costs for small firms. In this afternoon's second panel, we
will hear testimony from experts indicating that it is
impossible to know whether compliance costs will go down until
the new standards are implemented in a small business
environment.
Can you share with the Committee how you know that the new
standards will lower compliance costs for smaller companies and
by how much you expect the compliance costs to decrease?
Mr. Cox. Well, of course the benchmark for measuring any
reduction that might be anticipated in compliance costs has to
be what it costs today to comply. There are companies,
including companies with a below-$75 million public float that
have, for whatever reason, come into compliance early, and
those companies provide a benchmark. There is absolutely no
question that AS 5 is going to be more flexible for the reasons
that I outlined, more top-down, more risk-based, more
materiality focused and more scalable than it is predecessor,
AS 2.
For all of those reasons compliance is going to be much
less costly. The necessity for what I would consider to be
redundant, unnecessary or immaterial work will be eliminated.
The focus will be on what truly matters.
This is not to say that it will be a cost-free exercise.
But what we are seeking to do is bring the costs more in
alignment with the benefits. Since this is real work, it is
intended to produce real benefits. The investors are paying;
the investors deserve those benefits.
Chairwoman Velazquez. But you come here, sir, and you
testify to the fact that this is going to lower compliance
costs, that they will go down. In 2003, the Security and
Exchange Commission forecast that the average cost of SOX
compliance will be $91,000; this forecast proved to be a
significant underestimate of the actual compliance costs.
My understanding is that the SEC intends to release the new
management guidance and auditing standard without a cost
estimate. Can you tell us why this is?
Mr. Cox. In fact, the cost-benefit analysis that the law
requires, that the Regulatory Flexibility Act requires, will be
included as part of our submission to the Office of Management
and Budget, which I believe we are making today--if not today,
it will be tomorrow.
And with respect to that 2003 analysis of what SOX
compliance was expected then to cost, as you know, in 2003 I
was a Member of the House of Representatives and a member of
the Financial Services Committee; and like you, I voted for the
legislation with the understanding that Section 404 would
provide great benefits to the country and to investors and then
would not be unduly burdensome or cause waste.
The evidence that we have all seen since then indicates
that not only was that estimate wrong, but I think our
estimation as legislators of what was going to happen in
consequence of 404, modeled as it was on FDICIA, was also in
error. And that is why I am so firmly convinced that this needs
to be changed to bring it into alignment with congressional
intent.
Chairwoman Velazquez. Well, I am a member of the Financial
Services Committee, and I do support the spirit of the law. And
we all know the problems that we saw in terms of corporate
America scandal. We understand that.
In my role as the Chair now and ranking when we passed the
law, I consistently raised the issue about the impact that
Section 404 would have on small companies. The fact of the
matter is that we have the Regulatory Flexibility Act that
requires for agencies to conduct a full economic analysis,
impact analysis of the regulations. What we have seen and what
we have read about the regulatory flexibility analysis that you
have conducted, it looks to me to have been quite limited; and
we are concerned about that.
So I would like to see if you have more data or information
as to the regulatory flexibility analysis that you conducted to
share with this Committee.
Mr. Cox. Well, of course we will share with the Committee
any analyses that we have that you think would be of interest
to you. Beyond that, I think it is important to point out that
because we are staging compliance for smaller companies
differently from larger companies who will have to come into
compliance in 2008, we will have the benefit of that year. And
if the Commission learns that our estimations are in error,
that what we intend to happen is not what is happening, then we
will have the opportunity to consider further postponement of
compliance.
Chairwoman Velazquez. I am glad to hear that.
And now I will recognize Ranking Member Chabot.
Mr. Chabot. Thank you, Madam Chairwoman.
And, Chairman Cox, I will begin with you if I can. Would
you review for us what educational efforts the Commission is
undertaking for small businesses to make them more aware of the
new Sarbanes-Oxley Section 404 compliance requirements?
Mr. Cox. I would be pleased to do that.
We are right now in, essentially, the planning stages for
that effort because we don't yet have a new standard that is in
effect. And our management guidance, while it is, as I
mentioned, going to be 404(b), the review will not be
completely final for a short while. When that occurs and when
we can go out and talk about our new management guidance and
our new audit standard, we intend to have a special focus on
communicating with small business, not only in the usual ways
through speech making and our liaison with small business, but
also through our Office of Investor Education and Assistance.
We hope to prepare brochures that will be specially
designed for small business to accompany the management
guidance, which already was written with small business in
mind, meant to be flexible and so on. And I will do everything
that I can in a small business friendly way to communicate in
ways that small business can understand without hiring expert
help.
Mr. Chabot. Thank you.
Should the SEC be concerned that some small businesses are
deciding to list their stocks on foreign exchanges in order to
raise capital and avoid compliance with Sarbanes-Oxley Section
404?
Mr. Cox. Yes. There is no question that when companies list
in the United States that are stronger investor protections.
And so to the extent that U.S. investors are going to end up
owning any of these issues, we are all better off from an
investor protection standpoint if that activity occurs in the
United States.
So we are focused, as you might imagine, on ensuring that
our regulations and our entire theme is focused on getting the
maximum amount of investor protection with the maximum amount
of activity in U.S. capital markets.
Mr. Chabot. If the Commission prepared a final regulatory
flexibility analysis, did it estimate the cost of compliance
for small companies seeking to go public?
Mr. Cox. While we do not have a dollar figure attached to
that, it is, as I mentioned, because we will have the benefit
of a year of real-world experience before that requirement
kicks in.
Mr. Chabot. I yield to the chairwoman.
Chairwoman Velazquez. In order to comply with the
Regulatory Flexibility Act, you have to do a full cost
analysis, so where is the cost?
Mr. Cox. We did in fact comply fully with the requirements
of the Regulatory Flexibility Act, including Section 607.
Chairwoman Velazquez. But then you have a cost. What will
be the cost for small companies to comply?
Mr. Cox. Well, all I can tell you beyond that, because I
have been assured by both the Commission's counsel and the
Division of Corporation Finance that this is the case, that the
very same package that we are providing to OMB, I believe this
day, we will be able to happy to provide in real time to the
Committee.
Chairwoman Velazquez. And will you commit with this
Committee that if it doesn't have a full cost analysis,
compliance will be delayed until such an analysis is conducted?
Mr. Cox. Yes, of course; and compliance is already delayed.
But I will absolutely assure this Committee both today and
prospectively that we will be in full compliance with the
Regulatory Flexibility Act.
Mr. Chabot. Reclaiming my time, Mr. Olson, I will turn to
you now if I can.
There is no doubt that the audit standard requires a fair
amount of exercise of independent accounting judgment by
auditors. What is the likelihood that the exercise of such
judgment will increase the cost of audits?
Mr. Olson. Congressman, there is an element of accounting
judgment that goes into many accounting transactions, and--
because even as precise as our accounting standards are, there
still is a significant amount of judgment it involves.
The role of the PCAOB when we do the inspections is that we
look at the manner in which the accounting has been audited.
So--it is the audit component of it that we look at, and so
what we do is, we look at the extent to which the auditing
standards have been followed with respect to the accounting,
and where we see accounting treatment that we think is
questionable, it is at that point we refer that to the SEC.
But--it is the audit component that we look at, but one of
the reasons, as I think you are pointing out--and it takes a
great deal of skill to do this--is the fact that there is a lot
of judgment required in many of the accounting treatments.
Mr. Chabot. Thank you.
Will the board entertain recommendations from smaller
companies and their auditors as they gain experience with the
new audit standard in an effort to further reduce the cost of
the audit standard?
Mr. Olson. We meet continuously with the accounting
profession, with the audit profession, in a number of venues;
and our examination process is very dynamic, which is to say
that we are changing it continuously as we learn more.
You may remember, as you know, that we are a 4-year-old
organization; we have completed 3 full years of doing
inspections, and it was an inspection methodology that we had
to build from scratch. So we have been developing that
continuously and we have been working to improve it
continuously. As we have learned more and as the environment
has changed, and more importantly, as the auditing profession
has changed, we have changed our approach too.
So the answer to that is definitely "yes."
Mr. Chabot. Thank you. I am pleased to hear that, and I
would strongly encourage the board to take into consideration
what the small business folks and the auditors say as time goes
on, as they become more familiar with it.
And so I am glad to hear that.
Madam Chair, I yield back the balance of my time.
Chairwoman Velazquez. Ms. Clarke.
Ms. Clarke. Thank you very much, Madam Chair, for holding
this hearing today on this very critical issue. We must ensure
that these new guidelines being discussed today provide small
business the relief they so desperately need.
I would like to also just sort of highlight, Madam Chair,
your focus on the unintended consequences of this timeline that
is set forth to implement AS 5 and the management guidelines.
The roll-out is where we really need to focus right now, and I
think that has been some of what you have been hearing from the
Committee.
Chairman Cox, I wanted to ask that while the SEC approved
new management guidelines on May 23 to help navigate the
burdensome provision of the Sarbanes-Oxley Act, your
administration said it was not necessary to give smaller
companies additional time to comply with Section 404. But now
it appears, based on your testimony here today, that you are
willing to reconsider your decision.
Can you explain to us, why the sudden change in your
position?
Mr. Cox. Well, I don't believe that I have been
articulating different positions. I am merely trying to make it
clear that there are different timelines in place.
The management guidance that we are talking about is a
separate piece from AS 5, which the PCAOB is talking about.
That is going to go into effect a year later for smaller
companies, so we already have a built-in delay until 2008 for
management guidance and 2009 for AS 5, the PCAOB's audit
standard.
And then, in response to the Chairwoman's question about
what would happen if we learned as a result of the built-in
year of experiential base that we will have looking at AS 5
being utilized by our companies, if that doesn't turn out as we
intend, would we then consider further extension, the answer to
that is absolutely "yes."
And that has been our view consistently. We expressed that
at our recent public meeting. I think all the Commissioners are
of that view. It is expressed in the formal written testimony
that we provided though this Committee.
And by the way, because we are a five-member commission and
that written testimony presented, it has been voted upon and
approved by all five commissioners. So I think I speak very
much for all members of the Commission that is our view.
Ms. Clarke. And let me ask, you told Congress that your
administration would not require smaller public companies to
have a Section 404 audit until the new guideline and the new
auditing standard were available.
Now that you are reconsidering delaying the rules, what
standards will you examine to develop effective guidelines for
small businesses? Has that been identified?
Mr. Cox. Well, in fact the very guidance that we are
talking about hasn't yet gone into effect. No smaller companies
yet had the benefit of it, and we don't have any empirical
basis to know whether it is achieving its intended result. But
very soon we will. And we have done our level best at the SEC,
and I assure you at the PCAOB, that people have been working
very, very hard on this with small business uppermost in mind,
to make sure that this, unlike what preceded it, which in the
case of the SEC was absolutely nothing--there was no guidance
for management and people had to rely for the guidance on
auditors--and in the case of the PCAOB was AS 2, that this will
be much better and different.
And so we will soon benefit from all of that from companies
that have already had to comply with SOX 404. And as I said, I
strongly believe this is going to result in lower costs for
them. That is the intent. It should.
And then a year later, when smaller public companies come
on line, they should have the benefit of all of that experience
and knowledge, and we should be very highly confident at that
point that this is going to work as intended.
Ms. Clarke. Well, I would like to suggest, Mr. Cox, that
you make sure that this Committee is briefed as you go along
through this process; and that the triggers that are in place
to alert your agency as to whether there is going to be an
undue burden, that you closely monitor that.
I think that SOX 404 is critical. It is very important to
the investors and to the public trust. However, we don't want
to sink businesses in the process that are not at a capacity to
be able to absorb these new regulations in a way in which it
will be meaningful for their entry into the public arena in
providing us with the goods and services that we require as a
nation. So I hope that you will really monitor that very
closely.
Thank you very much, Madam Chair.
Chairwoman Velazquez. Mr. Larsen.
Mr. Larsen. Thank you, Madam Chair.
Just a few questions, Chairman Cox. Glad to have you before
the Committee. I am sure you are enjoying it as much as we are.
A quick question; this is certainly related to Mr. Chabot's
question about investor protection versus the listing in
foreign exchange markets. Are you seeing, assuming it has a
relationship to what we are dealing with, but maybe not direct,
maybe indirect--are you seeing a difference between new
listings being more predominantly focused on foreign exchange
markets versus a migration of existing public companies? Rather
than choosing to enlist here for their initial public offering,
choosing somewhere else versus existing public companies
seeking to raise dollars elsewhere or list separately overseas,
is there a difference at all in that which you are seeing as a
result of SOX?
Mr. Cox. Well, the focus has been on IPOs. And of course it
is much easier to make that election up front. But particularly
with respect to smaller companies we have not seen a great
deal.
There is no question that the vast majority of offerings
occur in the United States and not oversees, albeit if one
takes a look at the percentage changes in overseas markets,
such as AIM, you will see the trend is up.
Mr. Larsen. With regards to the management guidance and AS
5, I just want to get this straight.
What exists to ensure that the 404 guidance and AS 5 won't
migrate to companies above the line? That is, we want to ensure
that small businesses can comply so we are giving them some
extra time. Can we be assured that--obviously we want SOX to be
implemented for the reasons we saw a couple of years back; can
we be assured that no one else is going to come and try to
raise that line of who has to comply?
That is, it is going to be focused on small businesses for
the delay, and as we see this thing test out, can we be assured
that higher cap companies aren't going to return and say, well,
we want in on this too, we want to be delayed too? Because we
are seeing problems with some of these smaller companies and we
experience the same delays, can we be assured that the SEC is
going to stay focused on moving forward with SOX compliance?
We are really only talking about helping out the small
business side on this.
Mr. Cox. In fact we were talking about helping out all
companies, but as you point out, in a very different way.
With smaller companies it has been through deferral while
we craft a better, more suitable standard that they could
comply with in a scalable way. With larger companies they are
already in compliance with 404; they have had to comply. And so
what we are doing for them is changing what had been an overly
complicated and overly expensive and cumbersome standard to one
that is more flexible and more focused on the true material
risk about which investors care the most.
And so, in that way, I think that the new standard will
benefit companies of all sizes. But there is no reason to think
that we are going to take companies that are already in
compliance and tell them they can come out of compliance.
Mr. Larsen. Thank you, Madam Chair.
Chairwoman Velazquez. Mr. Ellsworth.
Mr. Ellsworth. Madam Chairwoman, I don't have any questions
for this panel.
Chairwoman Velazquez. I do have more questions. Mr. Olson,
the Advisory Committee on Smaller Public Companies to the
Securities and Exchange Commission and the biotechnology,
electronics, semiconductor, telecommunications and venture
capital industries have all recommended that the new standards
should include a revenue filter. As I understand it, the new
standards employ neither a gross revenue number nor an
indicator, like product revenue.
Why did the SEC and PCAOB opt not to follow the
recommendations of the advisory committee?
Mr. Olson. That is a very good question. We looked at the
extent to which we could make the standard scalable
particularly for small business, and as you may recall, in the
standard that we have produced in December the whole portion on
scalability was focused on small business.
And as we looked at that carefully the debate that went on
was whether or not--what were the thresholds or what were the
metrics that would determine whether or not a firm should be in
one category or another. And what we carefully wanted to avoid
was having what we would call buckets, that we would pull this
amount of revenue or this amount of revenue and then have that
apply to everybody in that category.
What we wanted to do instead was to have a standard that
was idiosyncratic; that is to say, that could focus on the size
and complexity of that individual company. And the manner in
which the standard is now written, it is part of the auditor's
responsibility to define at the outset the extent to which size
and complexity impact the manner in which they have scoped the
audit.
So I think that in fact we have addressed it in a way that
will be more applicable to the specific needs and the specific
size and complexity of the entity itself. For example, I know
that there are some very small banks, not very many of them,
but there are some very small banks that have very complex
balance sheets, and they will take one sort of internal
controls. There are also some very large companies that are
relatively not complex and the control structure that they
would put in place ought to reflect that.
With particular respect to the technology industry what you
tend to get is some very well-capitalized companies that have
very low revenue. I think for that reason they are saying we in
fact should be put in a category with some smaller firms.
In effect, we have done that by the manner in which we have
redone the scalability section by removing the small business
focus and making it applicable to entities of all size.
Chairwoman Velazquez. Chairman Cox, would you like to
comment on that?
Mr. Cox. Just technically, the SEC has not yet voted on
AS5. We will have an opportunity after exposure to public
comment to do so. So far we have been able to collaborate with
the PCAOB on drafting it, and I am certainly very familiar with
the discussion that you just had.
Chairwoman Velazquez. Mr. Olson, since the new standards
are principle-based and provide flexibility for auditors to
employ their professional judgment, the standards will create
significantly lower compliance costs only if they are
implemented properly. This means that the PCAOB's efficiency
inspectors have a very important role to play if the new
standards are to result in lower SOX 404 compliance cost.
So my question is how many efficiency inspectors doesPCAOB
have on staff and what month would the PCAOB begin inspecting
audited firms' implementation of the new standards?
Mr. Olson. First of all, you are exactly right. In terms of
the implementation, it is my sense that we have the words right
in the new standard and the key to it being more cost effective
is the implementation.
With our inspections of auditing firms, the inspections
include right now that we look at the efficiency and the
effectiveness on the audit of internal controls over financial
reporting only for those companies at this point, of course,
that are the accelerated filers. The same people do both. And
there are about 250 that we have in the field right now who are
doing those inspections.
Chairwoman Velazquez. Two hundred fifty.
Mr. Olson. Two hundred fifty. When we get to the point--
and, remember, it is the expectation that as the audits are
done that these will be integrated audits, so the audit of
internal controls and the financial audit will be done in an
integrated fashion. So it is important as we look--as we go out
and do the inspections that we are looking at both
simultaneously.
We would like to have in the area of 300 or so inspectors.
We think at that level we will have a full complement. That is
not exactly a fungible commodity out there, people with audit
experience, so we are having trouble finding enough good
people.
Chairwoman Velazquez. Chairman Cox, both the PCAOB and SEC
have used the term "right size" to describe what the recent
revisions will do to audits. What is meant by this term and
what do you envision a success?
Mr. Cox. This is related to the discussion that the
Chairman and Madam Chairwoman just had about complexity.
Companies come in all different shapes and sizes. The check-
the-box mentality was thought to be the Achilles heel of AS2.
AS5 takes a completely different approach. Our guidance for
management takes this same principle-based approach and also
permits reliance on judgment, reliance on the work of others.
It permits focus on materiality, on things that truly matter to
the financial statements.
By focusing on the control environment of a particular
company and making sure that what management understands it is
tasked to do is to assess its internal control system, not to
design an internal control system that is reverse-engineered
for the audit, it is going to make a big change.
Chairwoman Velazquez. What do you envision a success? How
would you measure it?
Mr. Cox. In two ways. We hope to get higher-quality
financial statements because we are focusing on the jugular and
no longer focused on the capillary. We are also hoping to
reduce the cost of compliance. This is not alchemy.
Chairwoman Velazquez. But you don't have the cost yet, the
cost of compliance, do you have it?
Mr. Cox. We certainly have current costs and we will very
quickly have empirical evidence about costs under the new
standard and the new guidance.
Chairwoman Velazquez. I am sorry; what was your answer
about the fact that you don't have a cost for compliance?
Mr. Cox. It is our estimate that costs will be
significantly lower for the reasons that we described. The
precision of our estimate is going to be in the putting, if you
will--that is to say, since companies are already in compliance
with a standard that we believe is more difficult than what we
are replacing it with, there is no one who has worked on this
that doesn't believe that costs ought to come down. This is the
purpose of the exercise.
Chairwoman Velazquez. If it doesn't come down?
Mr. Cox. Then of course we will revisit it immediately.
Chairwoman Velazquez. What would be the time line for that?
Mr. Cox. With respect to smaller companies, which I know
you are focused on intently in this Committee, the point of
having an opportunity to look at this for a year first is so
that we will have the benefit of that experiential base.
Chairwoman Velazquez. Okay. Any other member has a
question? Mr. Chabot.
Mr. Chabot. Thank you, Madam Chair. In the interest of
getting to the next panel I will just have one final question
here, and either or both of the witnesses could answer if they
want to.
Do you believe that the audit standard places the proper
emphasis on fraud risk, or should the standard be further
amended to impose a greater focus by the auditors on fraud
risk? Either one or both are welcome.
Mr. Olson. Congressman, one of the significant revisions
that we made in the final draft was to move up within the
standard itself the focus on fraud risk, because we think that
is very important and we wanted to make sure that the standard
highlighted the procedures that they ought to be taking in
order to attest for fraud risk exposure.
So I think with respect to the audit component of it, have
given it appropriate priority in the standard.
Chairwoman Velazquez. I have a last question for Chairman
Cox. Next month when the SEC receives public comments on AS5, e
small business community will be able to comment on the
proposed new auditing standard. So what input will be most
likely to encourage you to support a further extension of the
SOX 404 compliance for small companies?
Mr. Cox. I think that input would have to be in parallel
with comments on AS5 because AS5 doesn't contain the schedule.
I honestly don't want to tell the small business community what
they should be telling us. I think our point is we need to
listen, we need to be attentive to what they have to say. But
we will be. I think--
Chairwoman Velazquez. And you will be listening.
Mr. Cox. The important thing is that we are taking this
very, very seriously because we know, not only for companies
that are already public but for companies that have no publicly
traded shares and no IPO plan, their ability to raise capital
near term is in some measure a function of investors' sense
that someday they will be able to tap the public markets. So
for companies of all sizes, not just those on the verge of an
IPO, this is really important, and we understand that.
Chairwoman Velazquez. Any other member?
Mr. Chabot. Madam Chair, one final question. Sorry. Mr. Cox
is now obviously the head of the Securities and Exchange
Commission, but before--as you mentioned--that, he had a
distinguished career here in the House of Representatives. I'm
curious: Is it more fun to be up here asking the questions or
answering them? You don't have to answer that but you are
welcome to.
Mr. Larsen. I am sure it is a great pleasure for him to be
here answering our questions.
Mr. Cox. Well, you gave me the option of not answering. I
will say being invited to a congressional hearing and offered
the opportunity to not answer questions is truly enjoyable.
Mr. Chabot. Thank you. I yield back.
Chairwoman Velazquez. No other member has any comment or
question. Then the first panel is excused and I want to thank
both Chairmen Cox and Olson for their time, and I welcome you
back. I especially remind you, once again, the answers that we
are expecting regarding the Regulatory Flexibility Act, full
cost analysis, it is important for us too.
With that, I excuse the first panel.
I will ask the second panel of witnesses to take their
seats and the hearing will resume shortly.
[Recess.]
Chairwoman Velazquez. We are going to resume our hearing. I
want to welcome you all and thank you for your patience.
So our first witness is the Honorable James C. Greenwood.
He is President and CEO of the Biotechnology Industry
Organization in Washington, D.C., which represents more than
1,100 biotechnology companies. Prior to that he represented
Pennsylvania's Eighth District in the U.S. House of
Representatives from January 1993 through January 2005. While
serving in Congress Mr. Greenwood was a leader on health care
issues, authoring numerous bills signed into law, including
legislation to promote pediatric labeling for pharmaceuticals
and reform medical device review and approval. You are welcome.
It is good to see you back here in the House of
Representatives. You will have 5 minutes to make your
presentation.
STATEMENT OF JAMES C. GREENWOOD, PRESIDENT AND CEO,
BIOTECHNOLOGY INDUSTRY ORGANIZATION (BIO)
Mr. Greenwood. Thank you very much. Chairwoman Velazquez,
Ranking Member Chabot, and other members, I thank you for
providing the opportunity for us to testify before you today on
reforms to the Sarbanes-Oxley section 404 adopted by the
Securities and Exchange Commission and the Public Company
Accounting Oversight Board.
I am Jim Greenwood, President and CEO of the Biotechnology
Industry Organization. I am privileged to be here today on
behalf of BIO, an organization, as the Chairwoman said, of more
than 1,100 biotechnology companies, academic institutions, and
other organizations in all 50 U.S. States and 31 nations.
The promise of biotechnology is immense, as our members
combine in biology and technology to deliver new treatments for
unmet medical needs, improved crops that are more drought-
resistant and have reduced environmental impact and create
cheaper, more environmentally friendly fuels and consumer
products. Biotech is one of the most innovative, high-growth
sectors of our Nation's economy and one in which the United
States maintains global leadership.
First, I would like to start by providing a short answer to
the Committee's question posed in the title of this hearing as
to whether or not we believe the SECs and PSAOB's new standards
will lower compliance costs for small companies. In summary, it
is a marginal "yes." as this Committee well knows, it has been
the implementation of section 404 that has gone awry.
The situation that many emerging biotech companies face is
that funds that would be otherwise spent for core research and
development of new therapies for patients are instead having to
be used for overly complex controls or unnecessary evaluation
of controls. As a conferee for this legislation in 2002, I know
it was not intended to be a windfall for auditors nor pile on
the compliance costs for small companies.
The scale of the problems that section 404 has created
suggest that Congress should closely monitor the implementation
of these revisions to ensure that its original intent is
achieved. It is critical to ensure that these new rules provide
the greatest possible flexibility and scalability for small
public companies.
For most biotech companies, the actual cost of section 404
compliance, including both internal cost as well as external
auditor costs, are substantial. In fact, the opportunity costs
of section 404 for smaller companies can be even greater,
impeding the ability to invest in and, in some cases, to
continue critical research and development activities for
treatments of an array of diseases from cancer to multiple
sclerosis.
The current problem with section 404 are not merely growing
pains. Current implementation of section 404 imposes the same
requirements, steps and reviews by the same individuals year
after year. The Commission and the PCAOB have taken steps to
address the problems that have manifested in the implementation
of section 404. Both agencies suggest that these new
requirements are to be scaled, risk-based, and flexible. While
the SEC's final guidance is not yet public, we hope that it
will provide a more flexible principles-based set of rules for
management. On the other hand, the new standards adopted by the
PCAOB could still be improved to enhance flexibility and
auditor judgment.
Furthermore, one could fairly say that in its revisions to
its initial December 2006 draft, the PCAOB has actually taken a
step backward.
Included in both the Commission's and the PCAOB's draft
proposals were objective measures auditors could use in
determining what is a smaller company, mainly one with a market
capitalization of less than $700 million and reported annual
revenues of $250 million or less. This was consistent with the
recommendation of the Advisory Committee of Small Public
Companies. Who suggested that an objective test, particularly a
revenue filter, be used as a tool to define a smaller public
company than scaling the audit. Unfortunately, this definition
of the small company has been removed from the final PCAOB-
adopted rule.
Rather than maintaining the proposed objective definition
of a smaller company and then expanding it to include the
subjective criteria that could also be applied to parts of
larger companies, an approach which BIO supports, the PCAOB
removed the objective criteria altogether, and that is our
largest complaint. By eliminating any reference to market
capitalization or annual revenues, the PCAOB has taken away the
only objective criteria for scalability included in the rule.
In doing so, PCAOB appears to have moved from the presumption
that a company meeting those thresholds is a small company that
should be subjected to a scaled, less burdensome audit, to a
presumption that every enterprise should be subject to the
fullest, most comprehensive audit, unless the auditor
determines otherwise using the subjective criteria in the rule.
As a result of this change BIO believes that the new
standards may do less than the PCAOB's initial December 2006
revisions to counterbalance the incentives for auditors to be
overzealous in their work. Consequently, while we were hoping
for greater relief, it is now clear that PCAOB rules will lead
to substantially lower audit fees or reduced burden on emerging
biotech companies.
BIO has consistently advocated for scalability indicia that
are most reflective of complexity, and we still believe that
both the SEC and the PCAOB should recognize product revenue as
an important indicator of complexity.
In addition, BIO member companies have raised concerns that
after changing auditors they experience new interpretations of
material weakness. Even within the context of a principles-
based approach to auditing, some further clarification on this
guidance is needed. BIO believes that clarification in the
PCAOB-adopted rule should accomplish this.
Lastly, we strongly believe that a rigorous economic study
of the costs and benefits associated with the implementation of
section 404 is imperative to understanding if the current
reform proposals are meeting the objectives, and I believe that
the SEC analysis is qualitative and not quantitative, in answer
to the Chairwoman's questions. We urge the SEC to provide an
additional exception for non-accelerated filers. The Commission
has the ability to make the much needed changes that we have
mentioned.
In conclusion, BIO appreciates the efforts that both
agencies have taken to improve SARBOX implementation. It is
unclear, though, whether these reforms will fully match the
rhetoric surrounding their adoption. However, we remain hopeful
that this is just the first of several steps that both the
PCAOB and the SEC will take in reducing the unnecessary burdens
of Sarbanes-Oxley on America's emerging and innovative
companies.
I thank you for your time and your consideration of BIO's
views and I would be happy to answer any questions.
Chairwoman Velazquez. Thank you.
[The prepared statement of Mr. Greenwood may be found on
page 75 of the Appendix.]
Chairwoman Velazquez. Our next witness is Diane Casey-
Landry. She is President and CEO of America's Community
Bankers, a national trade association committed to
strengthening the competitive position of community banks.
Prior to joining ACB in 2000, Ms. Casey-Landry served as
Principal and National Director of Financial Services for Brand
Thorton LLP. Her past experience also includes serving as
Executive Director of the Independent Community Bankers of
America, and as a bank examiner for the Federal Reserve Bank of
Cleveland.
Welcome, and you have 5 minutes.
STATEMENT OF DIANE CASEY-LANDRY, PRESIDENT AND CEO, AMERICA'S
COMMUNITY BANKERS (ACB)
Ms. Casey-Landry. Thank you, Madam Chairwoman Velazquez and
Ranking Member Chabot and members of the Committee.
I am Diane Casey-Landry, President and CEO of America's
Community Bankers. Thank you for holding this very important
hearing today and for the invitation to appear today to present
to you our views on section 404 of the Sarbanes-Oxley Act and
the recent changes on the management guidance and auditing
standards made by the SEC and the PCAOP.
America's Community Bankers is the national trade
association for the Nation's community banks of all charter
types and sizes. Our members represent $1.7 trillion in assets,
they are located across this country and they are both stock,
public and private, as well as mutually owned institutions.
Sarbanes-Oxley was a well-intentioned law, and ACB has also
supported strong internal controls under the banking laws and
regulations. No other publicly traded company is subject to the
same scrutiny as a publicly traded bank. Because banks have
been governed by numerous internal control reporting and
assessment requirements long before Sarbanes-Oxley became law,
this creates both unnecessary and duplicative burdens on the
banking system.
The FDIC Improvement Act of 1991 dictates bank management's
responsibility for financial statements and internal control
assessments and attestations. This law actually served as the
model for section 404. However, the implementation of 404 has
been much more costly and burdensome.
As a meaningful reduction of this burden, ACB is supporting
H.R. 1508, which has been introduced by Representatives Greg
Meeks and Tom Feeney, which would create an exception from
Sarbanes-Oxley section 404 based on a company's size. We are
also supporting, similarly, the provision in H.R. 1869 which
would relieve community banks with up to $1 billion in assets
from the costly internal controls attestation reports of
Sarbanes-Oxley, a similar change which was made by the FDIC 2
years ago for the FDICIA banks and which ACB had requested.
We applaud the efforts of both the Commission as well as
the PCAOB to improve the implementation and reduce the
compliance costs of section 404 through this principles-based
approach. We are, however, very disappointed that the SEC
decided against a further extension of the compliance states
for non-accelerated filers despite several requests for such a
delay, including one from this Committee. Accelerated filers
have had 3 years of experience with the implementation process
and they are the best able to incorporate changes brought about
by the SEC and the PCAOB's recent action.
Community banks that are non-accelerated filers are very
much concerned about the cost and burdens of compliance. Non-
accelerated filers are the very companies that can least afford
to add personnel, consultants and systems to comply with
section 404. This is particularly true if the Commission's new
management guidance and the PCAOB's revised auditing standards
prove unsuccessful in reducing the costs and other burdens
associated with implementing section 404 as a result of the
actions by the accounting firms who have to implement these
changes.
With the filing deadline just 6 months away, we remain
hopeful that additional consideration for a reasonable 1-year
extension be given on this important issue. We are also calling
upon the Commission to update the Exchange Act threshold for
registration OF a public company from the 500 shareholder level
that was first imposed in 1964. Changes in market composition
and participation illustrate a need for the threshold to be
moved to a much higher range in order to provide overdue
regulatory relief for smaller companies that choose to be
public but choose not to be listed on an exchange.
Much has been said about the impact section 404 has on our
capital markets and on our Nation's ability to compete, and the
situation is really very grim from the standpoint of small
companies. Section 404 compliance costs have caused many
companies to either remain private or to consider going private
because the costs associated with being a public company
outweigh the benefits. For community banks, mergers and
acquisitions are frequently motivated by regulatory burden and
they often cite section 404 of Sarbanes-Oxley.
For example, as of today, the America's Community Bankers
NASDAQ index is comprised of 517 banking companies. It has a
market capitalization of $193 billion. Every year since the
index inception in 2003, approximately 50 companies have left
the index primarily because of mergers, but also because of
delistings. ACB has estimated that as many as 20 percent of the
departures each year from the index are because of a decision
to delist, triggered primarily by efforts to reduce burdens
created by Sarbanes-Oxley. And when community banks disappear,
local communities lose.
Notwithstanding the importance of internal controls, there
must always be balance with the costs and burdens imposed on
smaller public companies, and part of achieving this goal is to
reduce the amount of unnecessary regulatory burden hampering
the ability of small companies and small community banks to
compete domestically.
I very much appreciate the opportunity to appear before you
today and for your continued work on this important issue and I
would be pleased to answer any questions you will have. Thank
you very much.
Chairwoman Velazquez. Thank you very much.
[The prepared statement of Ms. Casey-Landry may be found on
page 84 of the Appendix.]
Chairwoman Velazquez. Our next witness, Mr. Hal Scott. He
is the Nomura Professor of the Program on International
Financial Systems at Harvard Law School. He teaches courses on
international finance and securities regulation. Professor
Scott is the director of the Committee on Capital Markets
Regulation and past Governor of the American Stock Exchange.
Before joining the Harvard faculty, Professor Scott clerked for
Justice Byron White. Welcome, sir.
STATEMENT OF HAL SCOTT, NOMURA PROFESSOR, DIRECTOR OF THE
PROGRAM ON INTERNATIONAL FINANCIAL SYSTEMS, HARVARD LAW SCHOOL
Mr. Scott. Thank you, Madam Chairwoman, Ranking Member
Cabot, and members of the Committee. Thank you for giving me
the opportunity to testify on this important issue on behalf of
the Committee on Capital Markets Regulation which I will refer
to, just to make it clear that it is our committee versus your
Committee, as the CCMR.
I would ask that my full written statement be incorporated
into the hearing record.
The CCMR is independent and bipartisan, composed of 23
corporate and financial leaders drawn from the investor
community, business, finance, law, accounting and academia.
CCMR issued its interim report on the state of the U.S. public
equity capital markets on November 30th 2006. The CCMR's
purpose is to explore a range of issues related to maintaining
and improving the competitiveness of U.S. capital markets.
In my remarks today I would like to make three central
points:
First, the debate over section 404 is a debate about the
health and future of small business as much as anything else,
because the costs of compliance, as you well know, fall hardest
on those entities least able to afford them. This issue is
about Main Street, not Wall Street, and it is important that
you are focused on that.
Second, you are right to press on the questions of costs of
compliance. As I will explain in a moment, neither we nor the
SEC or PCAOB know the answer to your question, and that is a
big problem if we are regulating in the dark on something so
central to the U.S. company.
Third, there is an action that the SEC can take that would
be helpful here. It should again delay applying both its rules
and the PCAOB's rules to small business so we can develop a
stronger factual record on the question of cost.
There is no denying that the costs of section 404 have been
significant. According to the Financial Executives
International, on a per-company basis SOX implementation costs
are 4.4 million in the first year, 3.8 million in the second
year, and 2.9 million in the third current year.
Despite the trend downward, 78 percent of the 200
executives surveyed by FEI said the cost of SOX section 404
still outweigh the benefits.
Recent actions by the SEC and PCAOB are a mixed bag. On the
positive side, certain important improvements have been made
that were called for by our committee. We strongly support a
top-down, risk-based approach that allows auditors and
management to make use of their judgment in tailoring their
evaluations of controls to the individual circumstances of
companies they audit, so-called scalability.
We support eliminating the requirement for an auditor to
examine management's evaluation process. We support the
increased flexibility provided for auditors to rely upon the
work of others and to limit the testing of low-risk controls.
Finally, we also commend the PCAOB's focus on fraud controls.
While we are supportive of these actions, we remain very
concerned about something that the agencies should have done
but have not. They have failed to provide a quantitative
standard for material, as applicable to both section 404 and
financial statement audits. Our committee recommended that
materiality for scoping an assessment should be defined as it
was traditionally, in terms of a 5 percent pretax income
threshold. This standard will be consistent with the overall
risk-based approach advocated by both the SEC and the PCAOB. In
cases where the 5 percent test would not be meaningful, the
agency should allow companies and their auditors to exercise
their reasoned judgment.
We are very concerned that without a presumptive
quantitative standard, the costs of compliance with section 404
will not be sufficiently reduced.
Our committee also recommended the completion of a thorough
cost-benefit analysis before the revised standards were applied
to small companies. This the agencies have not done. Instead
they intend to apply the new standards to all companies, big
and small, at the same time: 2008, the management standards;
and 2009 for the auditing standards.
To our way of thinking it is a real problem that no real
cost-benefit analysis has been done for any companies, at least
as part of the proposal. This appears inconsistent with the
requirements of Sarbanes-Oxley and Administrative Procedures
Act, as explained in more detail in my written testimony, as
well as sound public policy.
With all due respect, it is not sufficient for the SEC to
release a cost-benefit analysis with apparently no empirical
evidence after adopting its rule. If the agencies were to begin
by only applying the standards to companies over $75 million in
capitalization savings, they could field test for the cost of
the standards--I know I am running over my time, I will wrap up
shortly. They could field test for the cost of the standards to
the smallest of these large companies, for example, those
between 75 to 100 million in market capitalization. This could
give us a good idea what the cost would be for even smaller
companies.
Bear in mind that for small companies that have been not
yet required to apply section 404, a key issue is how much the
new standards will bring down first-year costs. Historically,
$4.4 million.
Our committee found that a substantial portion of the 404
costs, as high as 75 percent, were due to the management's
implementation of 404. Thus, these costs are not avoided by
only deferring to the PCAOB auditing rule. The SEC's management
rule goes into effect this year for 2008 statements.
In our view, if the SEC determines the benefits justify the
cost after field testing, the results of this determination,
both for management and for auditor implementation, should be
made public as part of a rulemaking procedure so that we all
have a chance to see what the data is and to comment on it.
Everyone-- companies, Congress and the public--is entitled to
know and comment on what the cost reductions would be.
By the way, Madam Chairwoman, one further thought. You made
the point, and I think quite insightfully, that it raises a
significant problem to implement the management part of the 404
before we implement the auditing part, because this puts the
management of these small companies in a position of having to
certify with high liability without the comfort of an auditor
review. I don't think this is a tenable situation for the
management of small companies to be in. Thank you very much.
Chairwoman Velazquez. Thank you, Professor Scott.
[The prepared statement of Mr. Scott may be found on page
93 of the Appendix.]
Chairwoman Velazquez. Our next witness is Mr. Mark Heesen.
He serves as President of the National Venture Capital
Association. Since joining NVCA in 1991 he has worked on behalf
of NVCA's 480 member companies to demonstrate the positive
impact of venture capital investment on the United States
economy. Prior to coming to the NVCA Mark was an aide to a
former Governor of Pennsylvania. Who was that?
Mr. Heesen. Dick Thornburg, many, many years ago.
Chairwoman Velazquez. Welcome.
STATEMENT OF MARK G. HEESEN, PRESIDENT, NATIONAL VENTURE
CAPITAL ASSOCIATION (NVCA)
Mr. Heesen. Thank you very much. Good afternoon.
Venture-backed companies accounted for 10.5 million U.S.
jobs and $2.5 trillion in revenues in 2006. Venture-backed
companies such as Google, Genentech, Starbucks, FedEx, Intel
and Microsoft were all once small and privately held, waiting
for the opportunity to go public. Today the next Microsoft is
waiting, but has yet to go public because of burdensome SOX
compliance.
In 2006 there were only 57 venture-backed IPOs on U.S.
exchanges but there were also 17 venture-backed IPOs on foreign
exchanges, something unheard of before Sarbanes-Oxley. What is
even more concerning is that what we are now seeing is that
companies that are viable U.S. IPO candidates are deciding to
be acquired instead of going public, mainly in an effort to rid
themselves of the SOX burden.
Imagine if Google had been acquired by Microsoft or if
Genentech had been acquired by J&J. Perhaps the innovation
would have survived, but the market value, the jobs, the
revenues all would have been diluted substantially.
We commend the SEC for its recognition of the SOX problem,
yet we do not believe that the combined SEC and PCAOB guidance
goes far enough to effect the necessary changes to relieve the
SOX burden for our smaller companies. We believe that three
drivers are critical in this regard:
First, we are gravely concerned that the accounting
profession will not change its high-cost practices and the
guidance provided by both the SEC and the PCAOB regarding
materiality is not specific enough to compel them to do so.
Second, the algopathy that exists for 404 audits leaves no
choice for small companies in terms of service providers.
Lastly, because of these first two concerns it is
imperative that prior to adoption all proposed measures are
fully field tested to confirm that they indeed will reduce
costs.
One area of guidance that we have had significant concern
about is the determination of what is material to sound
financial reporting. The original SOX language set the
probability threshold extremely low. Any area in which there
was, quote, more than a remote likelihood, unquote, for an
error to result in a material mistake on the financials was
required to be examined, documented and reported to the
company's audit company. This language comprised just about
everything.
Proposals put forth by both the SEC and PCAOB suggest
changing this language to, quote, reasonable possibility,
unquote. This general statement does nothing to distinguish
itself from the original language, leaves everything open to
interpretation, and will do little to reduce costs.
Although we support the move to enact principles-based
guidance, we feel there should be an objective threshold if we
are going to properly balance risk and cost. Since SOX was
enacted, the relationship between the Big Four accounting firms
and venture-backed companies has become increasingly
problematic. Many of our small companies have lost the
attention of their Big Four auditors, who are favoring larger
public companies that offer lucrative 404 auditing engagements.
Those who do maintain their Big Four relationships do so at a
404 cost that averages close to a million dollars annually.
As Sarbanes-Oxley allows only for accredited accounting
firms to complete 404 audits, our companies are basically held
hostage to this oligopoly. We would not have these concerns if
we had any comfort level that the Big Four accounting firms
support SOX reform, but the profession has publicly warned the
supporters of reform that, quote, they shouldn't expect a
dramatic reduction in costs, unquote, with the adoption of
these proposals. Anecdotally, our members are already being
told by their auditors don't expect much, if any, savings in
audit fees from the proposals as they are presently written.
While one would believe that private companies can bypass
the Big Four and engage a second-tier accounting firm, this is
frankly not a viable option. Investment banks that take these
companies public or sell them require a Big Four audit as a
sign of a clean bill of health. There is no competition.
The SEC should allow and Congress should support the
ability of accredited accounting professionals beyond the Big
Four to perform 404 attestations. By doing so we will create a
healthy, competitive ecosystem where the market will set the
right place for services rendered.
Despite an urgent need for reform we will ask today that
the SEC move forward cautiously while formalizing the proposed
guidance. Blindly adopting recommendations without field
testing them first would be akin to a venture capitalist
purchasing a company without doing due diligence. Field testing
ensures that, one, the recommendations will indeed reduce
costs; two, all the players, including the accounting
profession, are operating in the spirit of reform; and three,
that there are no unintended consequences.
Field testing will also allow the SEC to make the
adjustments as necessary without having to reopen a new
process. Let's prove that reform works before declaring
victory.
In conclusion, we are really at a critical inflection
point. The good work of all involved will be for naught if the
accounting profession does not get on board with cost reduction
or if implementation of these proposals fail. Taking the time
to field test and placing the needed pressure on the Big Four
to join the effort is required. We have waited way too long for
this reform to take place, but we are willing to wait longer to
make sure reform is right.
Thank you very much.
Chairwoman Velazquez. Thank you, Mr. Heesen.
[The prepared statement of Mr. Heesen may be found on page
99 of the Appendix.]
Chairwoman Velazquez. Our next witness is Mr. David
Hirschmann. He is the Senior Vice President of the U.S. Chamber
of Commerce and President of the U.S. Chamber Center for
Capital Markets Competitiveness. Mr. Hirschmann is a member of
the U.S. Chamber's management committee and in this position
helps shape the strategic direction of the world's largest
business federation, representing more than 3 million
businesses. Prior to joining the U.S. Chamber in 1992, Mr.
Hirschmann worked as a legislative director for former
Congressman Toby Roth. You are welcome.
STATEMENT OF DAVID HIRSCHMANN, PRESIDENT, U.S. CHAMBER CENTER
FOR CAPITAL MARKETS COMPETITIVENESS, U.S. CHAMBER OF COMMERCE
Mr. Hirschmann. Thank you, Chairwoman Velazquez, for having
me here today, Ranking Member Chabot, and members of the
Committee. I want to join the fellow panelists on this
Committee in commending you for holding the hearing and I would
like to make really four points:
First, we welcome the changes that the SEC and the PCAOB
have made to try to reflect in their rules what Congress
intended. We view the PCAOB's new auditing standard as well as
the SEC's guidance for management as significant steps forward.
We do think Chairman Cox and the Commission and Chairman
Olson and the Board should be commended for the leadership
effort they are putting in and we believe they are trying to
get it right. However, we will only know these efforts have
been successful after we see how they are implemented by the
auditors and companies and enforced by the PCAOB.
Third, until we have a full year of experience, we agree
with others who have called for a delay in implementing the new
rules. We believe it would be a mistake to make small
businesses the guinea pigs for the application of these new
rules.
It is important to remember that these rules are in place
for fiscal years that are currently running. In other words,
they are going to apply to activities that have happened in
companies already for 5 months; and management and the
accounting staff, which is very limited in small companies, are
having to prepare already for an activity, even though they
won't file the reports the next year, it is for things that are
currently happening. So in a way, small businesses are already
having to comply with rules that have not even been published.
This is profoundly unfair and sets up a train wreck because, at
the end of the day, the SEC won't know why it failed, if it
does fail, and we hope it doesn't. They won't know if it was
because the calendar they put in place was unworkable or the
new rules themselves have not achieved the job. We think this
is an avoidable train wreck that can be handled by a further
delay.
Fourth, we urge Congress and the SEC to work together to
address the additional critical issues that are making it
harder and harder for leaders of smaller public companies to
access the capital markets in order to grow their businesses
and create jobs. The Chamber strongly supported many of the
reforms in Sarbanes-Oxley, including more active and
independent boards and board committees. Effective internal
controls are an essential part of good financial governance for
all companies. However, the implementation of section 404 has
led to costs and compliance burdens which are far beyond what
Congress intended and well in excess of any benefits that can
be accrued to shareholders and management. This is amplified
among smaller public companies to the economies of scale.
Companies feel they are getting less effective advice from
their auditors, and auditors are increasingly being second-
guessed by their new regulator and the trial bar. The result is
predictable. Companies increasingly find the cost of being a
public company outweigh the benefits.
For well over a century this has been the greatest country
on Earth for entrepreneurs and innovators to access low-cost
capital to start and expand a business. Transparent and liquid
markets have been a key part of this.
The flawed implementation of Sarbanes-Oxley section 404 has
a disproportionate impact on the cost of capital for small
businesses that have already had to comply. For example, a $1-
to $2 million compliance price tag is an enormous burden for
companies that have $3 million in net income. Literally, we
have heard from companies that are forced to choose between
providing health care to their employees, buying new equipment,
investing in R&D, or complying with section 404. That is an
impossible choice to put a growing company through.
As Chairman Cox has noted, Congress never intended for the
404 process to become inflexible, burdensome and wasteful. The
Chamber has consistently called for a series of changes to fix
Sarbanes-Oxley 404, clarifying the terms such as material
weakness, significant deficiency and materiality, ensuring that
the rules are both risk-based and scalable, allowing for
greater use of the work of others, providing specific guidance
for IT systems and controls. We believe the SEC and PCAOB have
tried to address each of these areas and others; however, we
remain concerned about the extent to which the new standards
will improve on-the-ground implementation.
We also understand that SOX 404 has become somewhat of a
catch-all term to refer to a broader set of issues facing
public markets and smaller public companies in particular. U.S.
companies are facing changing retroactively applied accounting
rules that are ever-increasing in complexity. As a result one
in ten public companies is forced to restate their earnings
last year. This system is not working for companies, for
investors and for auditors.
America's securities class action litigation system is
broken. It provides an inadequate compensation to injured
parties without deterring future wrongdoers. It fails to
protect small, undiversified investors who seldom receive more
than pennies on the dollar, while attorneys on both sides rake
in millions of dollars in fees. The system is not working, and
security regulators struggle to keep up with the speed of
technology changes in today's rapidly changing markets. The
system is not working and our Nation is losing a key
competitive advantage much.
The challenge is clear and the voices are growing. We need
to work together to ensure that U.S. capital markets remain the
fairest, most efficient, transparent and attractive in the
world.
Chairman Velazquez, Ranking Member Chabot, I thank you for
the opportunity to discuss these issues and for paying such
serious attention to such important issues as capital formation
in our country.
Chairwoman Velazquez. Thank you, Mr. Hirschmann.
[The prepared statement of Mr. Hirschmann may be found on
page 104 of the Appendix.]
Chairwoman Velazquez. Now I recognize Ranking Member Chabot
for the purpose of introducing his constituent.
Mr. Chabot. Thank you very much. I have the distinct honor
to recognize our next witness who is actually from my
congressional district in the city of Cincinnati. It is Richard
G. Schmalzl who is with Graydon Head & Ritchey, which is one of
the top law firms in our area. He got his law degree, J.D.,
from the University of Virginia School of Law and LLM from
Georgetown University Law Center. He is a partner with the
firm, as I mentioned, of Graydon Head & Ritchey which is in
Cincinnati, Ohio. Mr. Schmalzl serves as co-chair of the firm's
Business and Financial Client Service Department. His law
practice has an emphasis on securities law, mergers and
acquisitions, private equity, venture capital, corporate
governance. Mr. Schmalzl's recent publications include an
article entitled "Sarbanes-Oxley: Coming Soon To Your Family
Business." we welcome you here this afternoon, Mr. Schmalzl.
STATEMENT OF RICHARD SCHMALZL, PARTNER, GRAYDON HEAD & RITCHEY
LLP, CINCINNATI, OHIO
Mr. Schmalzl. Good afternoon, Madam Chairwoman Velazquez,
Ranking Member Chabot and members of the Committee. Thank you
for inviting me to testify on the new 404 standards.
My name is Dick Schmalzl and I have practiced securities
laws for 25 years, primarily in Cincinnati, Ohio. I work
closely with large and small public companies in a variety of
industries. In recent years I have been on the front line with
CEOs, CFOs and boards of directors in helping them become
Sarbanes-Oxley compliant. I hope the Committee will find my
real-world experiences helpful to your consideration.
The views I share with the Committee today are my own views
and should not be attributed to my law firm, Graydon Head &
Ritchey, or to any client of my law firm.
I will address three primary topics: One, the most
significant problems that 404 has caused for public companies,
particularly small public companies; whether the new standards
are likely to effectively address those problems; and thirdly,
to urge the Committee to continue to evaluate the bigger
picture of whether 404 is serving its intended purposes.
My first topic is--I want to emphasize for you based on my
firsthand experiences--the three most troubling real problems
that 404 has caused.
First, as you well know, public companies are experiencing
at least a doubling of out-of-pocket audit costs. We all know,
and it has been well documented, these costs are
disproportionately burdensome to the smaller public companies.
The second problem that sometimes doesn't get as much
attention is substantial internal human resources must be
devoted to 404 compliance. This is especially problematic for
smaller companies who, even though they have highly qualified
CFOs as controllers, these persons must also play key roles in
operating and growing their businesses. Compliance takes away
from their ability to enhance shareholder value.
The third problem is that 404 has been a major contributor
to a deteriorating relationship between public companies and
their independent outside auditors. If companies have to ask
their auditors for advice on how to account for certain items,
the simple act of asking the question has raised the risk that
the company would be deemed to have a material weakness in
their internal control even though the outside auditors often
didn't have definitive answers either. So companies stopped
asking questions. They use their best judgment or hire a
different audit firm for advice, even though that second firm
doesn't know their business as well as their main auditors.
This is not healthy in light of increasingly complex accounting
rules.
These problems have also had more far-reaching consequences
as some of my fellow panelists have noted. Public companies are
increasingly looking at going private. For smaller public
companies, their boards and officers would probably not be
prudent fiduciaries if they didn't at least examine the going-
private alternative.
Also, successful private companies and dynamic new ventures
have virtually no aspiration to go public, regulatory burdens
being the number one obstacle. When I talk to potential clients
and existing clients about going public, they dismiss that idea
out of hand.
Thirdly, even investment banking firms are looking for ways
to avoid SEC registration for their clients by setting up
unregistered stock trading systems. These developments are not
healthy for small companies that want to grow by accessing the
public capital markets or for U.S. markets in general.
My second primary topic is whether the new standards will
effectively alleviate these most troubling 404 problems. I want
to commend the SEC and PCAOB on their extraordinary efforts in
identifying and analyzing these problems. I believe, and my
clients seem to agree, these new standards do an excellent job
in theory to address the above problems. However, a high level
of skepticism exists as to whether the new standards will work
in actual practice.
Out-of-pocket audit costs are not expected to reduce
significantly, by 10 to 15 percent at best. One of my small
non-accelerated filers has already been told by its accounting
firm that instead of having a 125 percent increase in audit
fees, it may only be 100 percent; i.e., a doubling of their
cost. Also, no substantial reduction at all is expected in the
internal resources needed to comply with the new rules. And
then, most importantly, significant concern exists whether the
outside auditors will buy into the new standards.
Without auditor buy-in, these standards can't work. Company
officers realize that the auditors have all the power, and they
have to do what the auditors want in order to obtain a clean
404 audit report. The SEC and PCAOB can only strongly emphasize
to auditors the importance to buy in, but the regulators are
probably limited in their ability to do this.
Also accountants likely and reasonably are concerned about
their risk of liability, and perhaps some protection from
liability would be warranted here as well. I think everyone who
has spoken here today, except the SEC and PCAOB, have agreed
that more time is needed for implementation. I certainly echo
that feeling. With respect to 404(a) and 404(b), management
cannot put these controls in place without knowing their
auditors are going to sign off.
Lastly, I want to ask the committee to continue to evaluate
the bigger picture of Section 404. Cost effectiveness is not
the only problem. My conversations with officers and directors
of public companies are uniform; they do not believe that 404
has significantly improved the quality of their financial
reporting. Rather, they think it has created a lot of
additional documentation, much of which is minutia. They also
believe that they had good internal controls before 404 came
into play and continue to do so. And perhaps most importantly,
they are adamant that 404 will not prevent another Enron type
fraud.
In summary, I would like to say, the implementation of 404
has been a significant burden for public companies,
particularly smaller ones. While the new standards provide some
relief, 404 compliance is likely to be burdensome on public
companies for years to come. Small public companies need more
time to comply, if not a permanent exemption. And lastly, the
jury should remain out and continue to evaluate whether 404
works at all. I appreciate the opportunity to have addressed
these issues with you. I will welcome any questions that you
might have. Thank you.
[The prepared statement of Mr. Schmalzl may be found on
page 111 of the Appendix.]
Chairwoman Velazquez. Thank you.
Professor Scott, I would like to address my first question
to you. You chair the Capital Markets Regulation Committee and
you examined the high cost of SOX 404 compliance and even
recommended that smaller public companies should not be
directed to implement SOX 404 until compliance costs are
contained. In fact, your committee recommended a thorough cost-
benefit analysis of SOX 404 should be conducted before a small
company would be directed to become SOX 404 compliant.
In your estimation, how long will it take to conduct a
thorough cost-benefit analysis of the new standard, and what
sort of data should be collected?
Mr. Scott. I am going to give you my guess on these
questions because I have not really thoroughly considered them
and talked to a lot of people. But I would say that this
certainly could be done within a year. We would need a year of
actual implementation of these standards to large companies, to
all companies other than the small companies, so we could
assess what the impact would be. As I said, during that period,
what we should be doing is looking at the closest cohorts to
the small companies, the $75 million to $100 million companies,
because that will give us a pretty good idea of what the impact
is going to be on the smaller ones. Also, during this year of
implementation to the large companies, which under the SEC's
proposal won't fully be done until statements are filed in
2009. So I would say that we are really talking about doing
this between 2007 today and during 2008. And I think, in
addition to kind of getting information from the closest
cohorts, they could interview in depth small companies. I sit
on a board in which the auditors come forward, as does
management, and tells us what it is going to cost. And I think
we could have the SEC and PCAOB interview these small companies
and ask them directly, what are these standards going to cost
you? What are the auditors going to charge? How would you
estimate the time and effort management was going to spend? And
as I said, Madam Chairwoman, the highest percentage of these
costs is for management. So it is really no answer to tell us
that we are going to defer the auditing piece of this for small
companies and implement the management piece let alone the
problem that a number of us have referred to, that the
management is left high and dry without any real comfort from
the auditors because they are not going to have to be Section
404 compliant for another year.
Chairwoman Velazquez. Thank you.
Mr. Hirschmann, you heard me asking this question to
Chairman Cox regarding the fact that under the existing time
line smaller public companies will not have to issue SOX 404
compliance financials until the spring of 2009. Corporate
executives however will not sign a management report without an
auditor's attestation. Will you find small companies have to
comply with both standards in advance of the December 2007
deadline?
Mr. Hirschmann. I think the result is predictable here,
unless we grant the delay. I think it is a very good question.
I think what you will see is that companies will have two
choices: Either they will go ahead and get their auditors
involved, and because this is coming out late in the year, they
will have to compete for attention of the auditors and may have
trouble doing so because the audit firms are not fully staffed
yet to provide that for smaller companies this year. So they
will have a very difficult environment with a very high cost if
they try to go that route.
Or they can try to do it without their auditor. But if they
do that, they risk that next year their auditor will come in
and say, wait a minute, what you did last year was not
adequate; we are finding material weaknesses here. And that is
an invitation for lawsuits and litigation and impacting the
price of stock and really setting back the entire company. So
you are really putting small businesses with two bad choices.
Chairwoman Velazquez. Thank you.
Mr. Greenwood, I know that your members, many of which are
small research and development companies, are particularly
concerned about the cost of complying with SOX 404. Since the
new standard of scalable and principal-based, why aren't they
sufficient to address your members' concerns about high
compliance costs?
Mr. Greenwood. Thank you. Fundamentally because, without
the objective standard of using market capitalization and/or
revenues, we think what will happen is that, given that the
auditors have double incentives to maximize the compliance
requirements--one, their fees; and, two, their liability--they
want to err, their tendency is to err on the side of requiring
more. So that is why we fear that our companies will not gain
access to the scalability benefits of the changes.
One of the things that is unique about our companies, I
think unique entirely to the sector, is that a biotech company
may begin with a molecule that its scientists think will cure
some kind of cancer. They then have years of research and years
of development. Then they go into phase one clinical trials,
phase two clinical trials, phase three. They make an
application before the FDA. They may have another year to wait.
All of that might take 10 to 12 years or more and may cost
hundreds of millions of dollars and yet they haven't earned a
penny in all of that time of revenue. And so, if you think
about it, I had the honor to chair when I was chairman of the
Oversight Investigation Subcommittee, to chair investigations
into companies like Enron and Global Crossing. And what would
those scandals have been? They were largely about officers of
companies who had stock options who wanted to exercise those
stock options, who wanted the value of the stock to continue to
inflate, who falsely stated earnings and revenues in an attempt
to meet the street's requirements and keep the stock pumped up.
That doesn't apply to these companies. These companies have no
revenues. They have no earnings. They only have investment. And
when you take a company that needs to spend all of its money on
research and development and then take significant segments,
sections of those invested dollars and use it for compliance
that provides really no value to the investor, it is truly
overburdensome. The final thing I would say on that, Madam
Chairman, is that what our companies tell us is that, when
potential investors ask them about Sarbanes-Oxley compliance,
it is not because they want to know how well protected they
will be as investors. It is because they want to know how much
money the company is wasting on SOX compliance.
Chairwoman Velazquez. Thank you.
Ms. Casey, you mentioned in your testimony about the
management of some community banks indicating that they are
seriously considering delisting. Can you talk to us, rather
than incurring the cost of SOX 404 compliance, can you talk to
us about what are the negative consequences to a community if
their bank chooses to delist?
Ms. Casey-Landry. Three years ago, we partnered with NASDAQ
to create an index for community banks to provide more
visibility in the capital markets for community banks and to
facilitate their ability to raise capital. What we have found
is, at the same time we did that, Sarbanes-Oxley came along.
And so the cost of being a public company suddenly rose
dramatically as the banks that were public were facing both the
audit costs as well as the 404. Because the index comprises
some banks that are accelerated filers, they have already been
in compliance positions. But as they began to look, the same
statement that was just made by my colleague up here, Honorable
Greenwood, about companies looking at what the investors were
saying, they are not saying, what is the value of the 404 to
improve the financial statements? They are saying, are you
taking away that investment that can go back into the
community, go back into the institution and will we be better
off being a private company? And so the decision really hinges
on whether or not the institution believes it can better serve
their community and stay serving that community and not be
forced to sell out. And some of them are making a decision to
stay independent, to stay as a community bank, they would be
better off being a private company, keeping those costs for the
institutions and not spending it with their auditors.
Chairwoman Velazquez. Thank you.
Mr. Heesen, I just will say that Section 404, Sarbanes-
Oxley 404 is the best protection that a venture capitalist like
yourself and your members will have regarding corporate fraud.
And yet I am impressed by how forceful you have been in
advocating to delay this implementation of SOX 404. Can you
explain?
Mr. Heesen. Absolutely. I do not know of a single venture
capitalist who would say the advantages of Section 404 outweigh
its disadvantages. And that is as an investor talking. A
venture capitalist wears two hats. He is an investor as well as
he sits on a board. But I do not know literally of a single
venture capitalist who would say the benefits outweigh the
problems that have been associated with 404. It is a drain on
the resources of the company. It is unquestionable. The money
needs to go one place in a merging growth company, and that is
into R&D. You want to grow that company and make it as
competitive as possible as quickly as you can. If you have
money being diverted to Sarbanes-Oxley's cause, that is money
being diverted from R&D. Basically that is a competitiveness
issue, very simply. But it also demonstrates that our companies
today take longer than they ever have to go public. And most
importantly, more and more of our CEOs are saying it is not
worth going public; I would rather get acquired. Now you are
still going to have to be Sarbanes-Oxley compliant to be
acquired, but they are just saying it is not worth it to
basically be in charge of a company that I am basically a
babysitter for regulation instead of a company builder. And so
they are selling out. And that is not good for the economy at
the end of the day.
Chairwoman Velazquez. Thank you.
Mr. Chabot.
Mr. Chabot. Thank you very much, Madam Chair.
Mr. Schmalzl, I'll start with you if to I can. You have
mentioned before that many of the companies that you are
dealing with are very hesitant, if not I think it is maybe
laughable to go public when one considers the additional
burdens that are imposed. Would you kind of discuss maybe
philosophically or with the economy in mind, what does it
really matter whether companies stay private or whether they go
public? What does that mean in the overall scheme of things? We
are a capitalist society obviously and want people to be
participatory in business and that whole thing. Could you talk
about that a little bit?
Mr. Schmalzl. Sure. I have always viewed the main reason
for a company to go public is that they want to be able to grow
their company. And being able to access the public capital
markets has been the most effective way of getting capital to
grow your company. Also that provides advantages for the
investing public as companies. You know, numerous--Microsoft,
Google. As the individual investors and institutional investors
can share in that growth, I think that is good for everyone.
With the public markets effectively being closed to these
growing companies who otherwise might be considering it, I
think we are cutting off a lot of opportunities for those
businesses, for the employees who work in those businesses
because their growth is stunted. And I agree with Mr. Heesen on
the inability for--you know, if these companies end up being
acquired by larger companies, the adverse effect on their
innovation isn't the same. I think we need to grow our own. And
if going public isn't a viable option for these companies I
think we feel the effects of that in a variety of ways across
our economy.
Mr. Chabot. Thank you. And Professor Scott, I noticed you
nodding. I don't know if it was the question or the answer. But
I would be happy to maybe throw you that softball, too, and ask
you to comment upon it. And maybe also keeping in mind what Mr.
Schmalzl also mentioned: It is not just the investors; it is
also folks that maybe would never fathom investing but
ultimately are going to need a place to work and support their
families and that sort of thing.
Mr. Scott. Right. Another aspect of this problem which the
committee thought was quite important was the fact that venture
capitalists, in order to create incentives for them to invest,
want to have a public exit. This has been the dream. The
venture capitalists come along, they invest. They nurture the
company, and the company goes public, and over a period of
time, the venture capitalists cash out and make money.
Now, if that result is limited because of the
unattractiveness of the public markets, what we are going to
see is less investment on the front end by venture capitalists
and small companies because this investment is going to be less
attractive to them because they can't cash out in the public
markets because of some of the costs that we have been talking
about. And this is fundamental. This investment fuels this
economy. Anything we do to interfere with it is a very serious
matter.
Mr. Chabot. And is it accurate to say that we are trying to
maintain some balance, because obviously if people are buying
stocks in companies or they have their pensions invested in
that company and people are crooked or doing things that they
shouldn't be doing, we want to protect them, but at the same
time not kill the goose that created this wonderful economy or
America that we enjoy.
Mr. Scott. Right. I totally agree with that. We are not
just focused on the cost, we are focused on the cost-benefit
relationship. So the issue here is whether the benefits from
404 exceed the costs. And those benefits that we are talking
about are to investors. That is why it is incumbent on the SEC
to do a very thorough empirical analysis of this issue before
we implement.
Mr. Chabot. Jim, let me start with you on this one if I
can, and we will just go down, anybody that would like to
comment. I'll make this my last question so we can get to some
other members. I believe you were all here, correct me if I'm
wrong about this, when both Chairman Cox and Chairman Olson
testified. Everybody was here I think during that. Could you
tell me what are one or more, depending on how you want to take
this, things that were said that you disagree with or that you
take issue with or that concern you about what you heard when
it comes to business and how 404 and all this affects
businesses in our communities around the country.
Mr. Greenwood. I think, Ranking Member, that the point that
I thought is most important in this entire hearing is really
about the loss of the quantitative threshold for smallness. Mr.
Olson's testimony was that they originally thought that was a
good idea and then, in reevaluating, it seemed not flexible
enough. And I would agree with him if the issue is, well, there
are companies that might exceed a $75 million revenue threshold
that are also very simple. And if that is the case and if the
PCAOB said maybe we want to give auditors the opportunity to
look at a company with $80 million or $100 million in revenue
that has very simple financials and also incorporate them into
this more scalable methodology. That is not what they did.
What they did is they did away with the quantitative
threshold all together. And we think, without that, as I
mentioned earlier, we think without that auditors will opt for
a more complex review and that it will be of extreme cost to
the companies really debilitating their abilities to do their
research and development and providing little if any additional
protection for investors.
Mr. Chabot. Thank you.
Ms. Casey-Landry.
Ms. Casey-Landry. Thank you, Ranking Member Chabot. I think
the comment that struck me the most was during the questioning
with the chairwoman regarding implementation of 404(a) and
404(b). The reality is that we are already in the fiscal year
for community banks and for any company. And the guidance isn't
finalized. It still has to go through the OMB process, and then
it needs to be out there. And I think the biggest challenge
that Chairman Olson and Chairman Cox need to recognize is, once
this is approved, that giving speeches and passing out
pamphlets is not going to be enough to educate the profession
with respect to how to handle 404 compliance for smaller
companies, and at the same time, these smaller companies will
have to begin to undertake the management review of their
internal controls. And like everybody else said, banks are
regulated by other entities, and they are not going to sign off
on an internal controls report for their bank regulators much
less for their auditors without these things being right. So I
think the 1 year extension is absolutely critical.
Mr. Chabot. Thank you.
Professor Scott.
Mr. Scott. Three points. First of all, adopting 404 for
small companies without a thorough cost-benefit analysis in
advance of the adoption. Second, bifurcating the implementation
of the management and auditor standards in two different years.
And third, not adopting a quantitative standard for materiality
in the guidance.
Mr. Chabot. Thank you very much.
Mr. Heesen.
Mr. Heesen. I was, frankly, very surprised at the total
lack of recognition that this regulation rule actually has to
be implemented and that accountants are going to implement this
and that you can have anything you want on paper. But if the
accounting community doesn't actually want to implement this,
they are not going to implement it. And I think that is an
issue that is not being addressed at all. I think that as it
stands right now, the big four are holding a lot of cards here.
And if they don't want to see these changes implemented, they
are going to have the power not to implement them. And no one
that I heard from either the SEC or the PCAOB are talking about
what I view as a very basic issue here, and that is
implementation of these things.
Mr. Chabot. Thank you.
Mr. Hirschmann.
Mr. Hirschmann. I have three quick points. First is, I was
surprised to hear Chairman Cox say that he feels like he is
close to the finish line. I really think this is an important
step, but we are not yet at the finish line. And the
implementation is important. I would hope that the SEC and the
PCAOB would open to make additional changes if needed. Second,
with regard to the PCAOB and the inspections process, until
auditors feel that they will not be second guessed, if they
simply don't repeat what they have already been doing, I don't
think you can expect auditors facing huge liability to change
the way they approach. So a change to the inspections process
at the PCAOB is very important. And third is the cost-benefit
issue. And I would just point out, there are a lot of good
people working at the SEC. It is a good agency. But the ability
to conduct a cost-benefit analysis is a material weakness at
the SEC. They simply cannot do it consistently well. It is been
the subject of litigation which they have consistently lost and
this is just another proof that they don't have the ability to
do it.
Mr. Chabot. Thank you. Finally Mr. Schmalzl.
Mr. Schmalzl. Yes. I would echo all the same points. First,
I was a little dismayed that it seemed to me that Chairman Cox
really didn't understand in practice what it takes to comply
with 404(a). The internal resources needed that management
needs to devote to that process is significant regardless of
whether or not you add the out-of-pocket audit cost to that.
Second, I didn't think there was enough credence given to
how much power the auditors have in this process. Unless the
SEC and PCAOB can get some confidence that the auditors are
going to buy into these standards, I think the people I talk
with at public companies really think that the process is
futile unless the auditors buy in.
And then, thirdly, I believe the SEC pretty much assumes at
this point that 404 is working and that it prevents fraud and
that it is creating investor confidence. My clients clearly do
not believe that. Their feeling is that the market really
doesn't care about these reports and that, as others have said,
what they care about is, how much is it costing you to obtain
that report? So I think that, to the extent that the SEC or
PCAOB have essentially declared victory on the 404 point, I
think that is mistaken.
Mr. Chabot. Thank you very much. I want to thank the entire
panel for their answers. I yield back.
Chairwoman Velazquez. Mr. Ellsworth.
Mr. Ellsworth. Thank you, Madam Chairwoman.
Thank you all for coming. It is very informative, for you
holding the hearing and for you all testifying. I found it
fascinating. I guess, first, a couple of observations. One, we
keep talking about an extension. And I come to find that if
people just give me bad news and tell me, if they come up and
tell me, hey, I am going to punch you in the nose right now or
punch you in 5 minutes, I still bleed and my nose still hurts 5
minutes later. And so just an extension doesn't sound like a
fix. Is it fair to say that no one on this panel believes that
we can achieve the intended goal of 404 the way it is written
right now? I think I am safe in assuming that we are not
achieving the goal. And I see some heads shaking. If you can
give me that nod I'll take that as the affirmative.
So those two observations being said, I don't know,
Professor, maybe you are the first one or Mr. Hirschmann, I
don't know; what is the fix? If I gave you the magic wand or
the magic pen, you know what we want to do, or what was
intended here? What is the best way? Do we make it go away
totally, wave the wand and make it go away, or what is the
bullet point fix on this?
Mr. Scott. Well, I think there should be a two-stage fix.
The first stage is that we should adopt reforms, part of which
have been done, but more that need to be done, particularly a
quantitative materiality standard. And then field test this in
terms of the cost and benefits to small companies. Now, if the
costs still outweigh the benefits, which they may well be, then
I think the Congress has to address this. What our committee
said is, in that event, what the Congress should do is to
exempt small companies from the auditor attestation
requirement. At the same time, however, because management
would not have the comfort of this outside auditor opinion,
that the certification standard that management now has, which
is pretty high, be lowered in terms of what management would
really have to say about their confidence in the internal
controls.
But before we ever get there, Congressman, I think the
first step is, let's do whatever we can to make this a more
efficient system. And I think there are steps yet to be taken.
And when we do that, let's figure out what the cost benefit is,
a thorough study, for small companies. And only if that doesn't
work should the Congress come back into the picture.
Ms. Casey-Landry. May I just point out that the bill that
was introduced by Representatives Greg Meeks and Tom Feeney
would provide an exemption for smaller companies. And I think
that would be something that would be worthy of Congress
considering. But that is a broader question and some other
committees get involved in that.
Mr. Hirschmann. I do think they are trying to fix the
problem. And part of the challenge is they don't have the tools
in their hands to completely solve the problem. They can
certainly fix the implementation of 404. What they cannot do is
address the rest of the equation which is the complexity of our
accounting standards, the fact that accounting rules are
increasingly complex, interpreted retroactively, they are
forcing one in ten public companies with an escalating number
every year to restate their earnings. The whole litigation
environment around auditors, there is a bigger picture here
that goes beyond 404. And I don't think until you address all
those pieces you can really ultimately solve this for anybody.
Mr. Greenwood. I would reiterate that the real fix is
probably to go back and provide a complete exemption for the
smaller companies. And I would base that on revenue, not on
market capitalization because market capitalization can, A
fluctuate wildly. A biotech company may have a drug. And based
on the promise of that drug, its stock value may be here. And
in clinical trials, it doesn't prove out to do what the company
hoped it would. So the market cap drops precipitously. There
are still no revenues coming into the company. So I would use a
revenue test for exemptions. And Congress should certainly
seriously consider doing that. And I don't think that it would
be, as somebody who has spent 24 years in public office, I
don't think there would be a public reaction that would be
negative. I think people instinctively understand that small
companies are not the Enrons and the Global Crossings and the
WorldComs.
Mr. Schmalzl. I would like to add to that I would agree
that a broader exemption for small public companies defined in
a different way would be a big advantage. And I think there
should be a net revenue and/or gross revenue test attached to
that. Also I would like to say that I am not at all negative on
Sarbanes-Oxley. I think Sarbanes-Oxley has done an awful lot of
good things for public companies. Boards of directors are more
effective. Audit committees are much more effective. There is
more information into the factor faster. Those are all very
good positives about Sarbanes-Oxley. And I think we achieve all
of those without 404 and without the incredible costs
associated with 404. So I wouldn't rule out the possibility of
appealing it for everybody. But if we are not going to do that
I would certainly try to exempt out a larger batch of those
smaller companies, particularly ones that are still struggling
to get to a revenue level that really can support these kind of
costs.
Mr. Heesen. I just look at it from the angle that the SEC,
Small Business Committee that looked at this issue came up with
these kinds of proposals. They were rejected basically by two
very strong votes, and that was the accounting firms. And so I
think, once again, you have to look at this and say, what at
the end of the day will the accounting industry feel
comfortable with that businesses also can feel comfortable
with? And that is a hard balance. But even from our companies,
companies that are going to be acquired today, I don't care how
big or how small they are, they are going to have to be
Sarbanes-Oxley compliant. A bigger company is not going to
acquire a smaller company unless all the Is are dotted and all
the Ts are crossed. It is just too much liability coming in.
And so this goes beyond simply trying to say, let's exempt X
amount of companies and it will solve everything, because
frankly it won't.
Mr. Ellsworth. Thank you all very much. I yield any time I
might have.
Chairwoman Velazquez. Thank you.
Jim, you spoke about the cost for your members in terms of
Section 404. My question to you is, does your organization plan
to collect data that quantifies compliance costs for new
members before and after the new standards are in place. And if
you are going to do that, would you be willing to share that
data with us.
Mr. Greenwood. Absolutely we would be willing to do that.
We have lots of anecdotal data, some of which we have shared
with your staff, Madam Chairwoman. But we would certainly be
looking forward to working with your committee on compiling
data with our members that would be helpful in your decision
making.
Chairwoman Velazquez. Thank you.
Mr. Heesen, several studies have cited evidence that the
U.S. stock markets are becoming less competitive, and some have
suggested that expensive regulation, including Section 404, may
be partly to blame. In fact the mayor of New York, Mr.
Bloomberg, released one of those studies. Can you comment on
the relationship, if any, that you see between SOX 404
compliance and the apparent increase in the number of firms
deciding to list their shares on full markets.
Mr. Heesen. I think part of it is Sarbanes-Oxley. I think
it is unfair to blame Sarbanes-Oxley for everything. I think we
are living in a much more global economy today. There are many
foreign exchangers that are much better today than they were 5
years ago. Having said that, I think many of them have gotten
better because of Sarbanes-Oxley. I think they have gotten much
more aggressive in coming into the U.S. and marketing to our
companies and saying please let's go public on AIM or on Tokyo
or somewhere else. You are also seeing companies that venture
capitalists have backed that may be based in another country
that in the past would have gone public on NASDAQ and instead
today are going public on the Bombay exchange or on the Tokyo
exchange. Now, part of that is because they are in their home
country. But the other part of that is because those exchanges
have gotten better and smarter and much more aggressive than
NASDAQ has because of Sarbanes-Oxley. So some of it actually is
very much a part of Sarbanes-Oxley. Some of it is part of just
globalization in general.
Chairwoman Velazquez. Definitely. And I did not intend to
say that it is just only to blame for Section 404, but is the
cost of regulations, including Section 404. Professor Scott, do
you mind to comment?
Mr. Scott. Yes. Of course, this was a major finding of our
committee's report that a number of factors were leading our
public markets to be less competitive. In addition to
regulation in general, which you have observed 404 is part of,
we have two other concerns. First of all, the cost of
litigation here, which is very high on the list of why foreign
companies do not want to come to the United States. And
secondly, in view of our committee, a deficit in the rights of
shareholders in the United States compared to our countries.
For example, other countries permit their shareholders to vote
on the adoption of poisoned pills which are an impediment to
takeovers. Our public company's shareholders don't have those
rights. We have a possibility of having plurality voting rather
than majority voting. So I would say in addition to regulations
the cost of litigation and the deficit in shareholder rights.
That was the conclusion. And as Mark observed, foreign markets
are becoming more competitive. The point is, we can't just do
what we want to do anymore. This is a competitive world, and we
have to accept that reality.
Chairwoman Velazquez. Yes.
Ms. Casey-Landry. I just wanted to make one comment.
Community banks don't have the option to go to another
exchange. And if they want to stay public and they want to have
access to the capital markets then we need to have a system
that is fair so that they can go to NASDAQ, they are going to
go to the New York Stock Exchange, and they be listed and that
they can be competitive. When we place undue burdens on smaller
companies that can't go global then we are really affecting our
own base and own economy. And I would just point out that 404
has been a problem. And at the same time you do have community
banks. We just added another 50 banks to our index in the past
6 months. But, I mean, banks that chose to go public. So there
are companies that are still going public at the same time
those are choosing to delist. But it is important to keep it
domestically focused, too.
Chairwoman Velazquez. Thank you.
Any other witness? Yes, Mr. Hirschmann.
Mr. Hirschmann. I want to just agree with the point that
there is a lot of good in Sarbanes-Oxley. But the168 words of
Section 404 we refer to as the 168 words that stole the act. So
I hope that not the final words. And I commend the committee
for holding this hearing and look forward to working with you
to make the changes that are needed.
Chairwoman Velazquez. Thank you. Mr. Chabot.
Mr. Chabot. Thank you, Madam Chair.
I just want to once again commend you for holding this
hearing and thank you for doing so and thank the panel here. I
thought they gave us some very insightful information. And I
want to especially thank Mr. Schmalzl for coming all the way
from my district back in Cincinnati, but I thought everybody
here was really very good and we appreciate you holding this
hearing.
Chairwoman Velazquez. I echo the remarks made by the
Ranking Member. It has been a great hearing, and I believe
that, yes, there is so much good on Sarbanes-Oxley, but we have
to make sure that we get it right. And I don't see the rush in
terms of compliance right away without knowing and having the
empirical data that shows that there is the cost-benefit
analysis that will help the small companies to continue to grow
and do what you do best in this country and our economy, and
that is the research, the development, but at the end, job
creation, and that is very important. So with that, I want to
thank all of the witnesses. And members wishing to submit
statements or documents into the hearing record will have five
legislative days to do so. This hearing is now adjourned. Thank
you.
[Whereupon, at 4:45 p.m., the committee was adjourned.]
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