SEC Advisory Committee Reports on Internal Controls for Small Companies

On December 17, 2005 the Internal Controls Subcommittee to the Advisory Committee on Small Public Companies issued a Preliminary Report.  Report  The Subcommittee recommended that Microcap Companies (with a market capitalization of under $100 million) be totally exempted from Section 404 of Sarbanes-Oxley requiring both a CEO certification and an audit of the effectiveness of a company's internal control systems.  It also recommended that Smaller Companies 9with a market capitalization of $100 million to $700 million) be exempted from the audit requirements of Section 404 (the CEO will still have to certify the effectiveness of the company's internal controls).  It is unknown whether the SEC will adopt the recommendation.  The Report found that the costs of Section 404 were much higher than expected and were disproportionally higher for smaller companies, that internal controls were not as necessary in smaller companies and did not provide the same benefits as those in larger companies, that there is no clear SEC guidance on how to apply the SOX requirements to smaller companies, that investors know that smaller companies pose a greater risk of management fraud, and that there are other more effective methods of stopping management fraud in small companies.  Finally, in its most important finding, the Subcommittee found that applying Section 404 to smaller companies would hurt the United States economy by chilling the capital formation in small publicly traded companies.  This is a welcome note of sanity in the Sarbanes Oxley discussion.  Whether the SEC will do anything with the report is anyone's guess.