June 16, 2005
Section 404's Effect on Small Companies
On the heels of the financial scandals of 2001, Congress passed the
Sarbanes-Oxley Act of 2002. President Bush signed the new law, hailing it as
the most significant piece of federal legislation on business regulation
since the New Deal legislation, the Securities Act of 1933 and the
Securities and Exchange Act of 1934.
Sarbanes-Oxley was a polyglot of provisions, patched together in a
hurry to reassure the American people that Congress and the president were
responding to the financial scandals. Several of the provisions phased in
over time. This means we are just now learning the effect some of the act's
more important provisions will have on business practice.
The most problematic provision - Section 404 - is just now coming on
line. The section is seductively simple. The section directs the U.S.
Securities and Exchange Commission, our federal agency that regulates
securities trading, to write rules requiring the managers of a publicly
traded company to declare, in the company's annual report, that the company
has internal control procedures in place to test the accuracy of the
company's financial statements and that the procedures are "effective."
Congress then requires that a company's auditors must "attest" to the
It seemed like a minor incremental improvement in a company's
reporting requirements. Since 1977, Congress has required that all publicly
traded companies have internal control procedures in place. Now Congress
wanted companies to "take them seriously."
The SEC wrote the Section 404 rules in 2003 and estimated costs of
around $90,000 per company to implement the rules. The SEC dismissed the
additional audit costs as "minimal." It was one of the worst understatements
in the agency's history.
Companies with total capitalizations of more than $200 million have
had to comply with the new rules since November. We now know that it costs
an average of $4.3 million per company to comply with the new rules, with
$1.3 million of that in additional audit costs.
Smaller companies with less than $75 million in total
capitalizations have until July 2006 to comply; they have asked for and
received three extensions, arguing that they cannot afford double or triple
the audit fees. The costs are regressive; the new rules create a larger
percentage cost increase for smaller companies than for larger companies.
The immediate effect, in anticipation of the effectiveness of the
rule on smaller companies, is to cause smaller companies to "go dark," that
is, to reduce their number of shareholders to less than 300 so they do not
have to comply with the rules. Initial Public Offerings are off as small
private companies have decided not to go public by selling stock in
registered offerings to the general public.
The long-run affect of Section 404 on smaller companies is that the
smaller companies will be disadvantaged in their competition with larger
companies, as if they did not have enough problems already. The SEC has
formed an advisory committee, chaired by a Chicago lawyer, to consider the
plight of small companies. It is not clear what they can do.
Section 404 looks good from 30 feet away, but up close, it has some
very unappealing dents and paint chips. The nation's smaller companies are
paying a disproportionate tax for the sins of Enron Corp. and WorldCom Inc.,
two financial disasters caused by large companies.
June 16, 2005 | Permalink
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