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Sarbanes-Oxley Section 404: Will We See More?

Appearing at her second Congressional hearing in as many weeks relating to small business capital formation, SEC Division of Corporation Finance Director Meredith Cross testified to the House Financial Services Committee earlier today on various initiatives the SEC is considering to better facilitate small business capital formation, while still adhering to its investor protection mandate. *** UPDATE: See the link to the hearing webpage, which includes links to all testimony and some related proposed legislation.

I found her prepared remarks on Sarbanes-Oxley Section 404 to be of the most interest, as summarized below. (Please note the disclaimer that appears on the right side of this blog).

Note: I did not listen to the live webcast of the hearing, this summary is based on written testimony and draft legislation; if other bloggers out there live-blogged (or live-tweeted) the hearing, I invite you to post a comment or send me an email with a link to your blog post or twitter handle.).

In her testimony today, SEC’s Cross noted that the Dodd-Frank Act amended Sarbox by exempting non-accelerated filers (i.e. companies with less than $75 million market cap). A footnote in her testimony linked to the SEC’s study, also mandated by the Dodd-Frank Act, as to whether further exemptions or other improvements could be made with respect to the rules pertaining to Sarbox 404, for companies with over $75 million market cap and less than $250 million market cap; that study concluded there should be no further exemptions, and that further study would be given to potential improvements.

She reiterated in her testimony today, in language similar to that used in the SEC’s Sarbox study referenced above, that:

The staff encourages activities that have the potential to further improve both the effectiveness and the efficiency of the evaluation of internal controls, while maintaining important investor protection safeguards. For example, with this objective in mind, the staff continues to work with the PCAOB to monitor inspection results and assess the extent to which publishing observations can be useful.

 

She added:

The staff is also observing COSO’s (Committee of Sponsoring Organizations of the Treadway Commission) project to review and update its internal control framework, which is the most common framework used by management and auditors alike in performing assessments of internal control over financial reporting.

NOTE: We previously reported that an Exposure Draft of the update to COSO’s 1992 Internal Control-Integrated Framework is expected to be released for public comment later this year.

Congress Gets Into The Act

Various members of Congress have circulated proposals to further amend Sarbanes-Oxley Section 404 by increasing the threshold level of exemptions from the Sarbox Section 404(b) auditor’s report on internal control (i.e., increasing the exemption level provided in the Dodd-Frank Act) and in some cases by providing certain opt-outs for companies up to a threshold level of, in some proposals, $1 billion, with some bills specifying the company would need to disclose if it took advantage of that opt-out (aka, what some may describe as ‘comply or explain.”)

For example, Cross referenced draft legislation proposed by Rep. Stephen Fincher (R-TN). Fincher’s draft bill, the Small Company Job Growth and Regulatory Relief Act of 2011 would further amend Sarbox 404 by:

·       increasing the threshold level of companies exempted from the Sarbox 404(b) auditor’s report on internal control, from the current level of $75 million, to a level of $500 million, and

o   provide an additional exemption for companies between $500 million and $1 billion of market cap: “(1) for the first five years following the registration of securities of an issuer that first registers after the enactment of the Small Company Job Growth and Regulatory Relief Act of 2011,” or (2) any report filed pursuant to subsection (a) by an issuer that has opted out of subsection (b), by consent of its shareholders by majority vote.” 

It appears to me (see the disclaimer on the right side of this blog) that Rep Fincher’s bill is proposing a permanent opt-out from Sarbox 404(b) – if and only if there is majority shareholder approval - for companies with less than $1 billion market cap.

In contrast, a similar bill in circulation, “The Startup Expansion and Investment Act,” sponsored by Rep. Ben Quayle (R-AZ), appears to provide a ‘comply or explain;’ type opt out for a time limited period (10 years) for companies with less than $1 billion market cap. As described in Rep Quayle’s press release:

Specifically, the bill allows new companies with a market capitalization under $1 billion to opt-out of regulations within section 404 of the Sarbanes-Oxley Act for the first ten years after going public. To inform investors, a company must clearly disclose in its annual reports that it chose to opt out of section 404.

Props to former SEC Chief Accountant Lynn E. Turner for bringing the Quayle bill to my attention through an email news listerv he provides. Of course, he added his own commentary to his email, (subject line “Short Memories”), in which he stated, “Clearly people have forgotten the hundreds of billions in dollars of losses investors suffered during the corporate financial reporting frauds, and the tens of thousands of jobs lost [from those frauds].”

 

CFA Institute, CAQ, and CII Caution Against Further Sarbox Exemptions

Yesterday, a joint letter was sent by the CFA Institute, the Center for Audit Quality, and the Council of Institutional Investors, to the Chairman (Rep. Spencer Bachus) and Ranking Member (Rep. Barney Frank) of the House Financial Services Committee (sponsor of today’s hearing), stating:

We understand that the Committee is considering legislation that could weaken certain investor protections of the Sarbanes-Oxley Act of 2002 (SOX). The Center for Audit Quality, the Council for Institutional Investors, and CFA Institute are writing to urge you to resist efforts to further weaken SOX by exempting even more public companies from compliance with Section 404(b) of the Act, which requires an independent audit of a company’s assessment of its internal controls as a component of its financial statement audit.

Read more in the CFA Institute, CAQ, CII Sept. 20 letter.

SEC IG Issues Report on Conflicts of Interest

In the interim period between the two Congressional hearings addressing crowdfunding and other small business capital formation matters, the SEC’s Inspector General publicly released his report and recommendations entitled: Investigation of Conflict of Interest Arising from Former General Counsel's Participation in Madoff-Related Matters. The report examined the involvement of former SEC General Counsel David M. Becker in certain matters relating to the Madoff liquidation, in light of his having inherited some funds from his late mother’s estate which came from liquidation of an investment in Madoff securities. Becker had received clearance from the SEC Ethics Officer to participate in matters relating to the Madoff liquidation. Among parties sued by the Madoff bankruptcy Trustee for clawback of a certain portion of funds received were the Becker estate.

In response to the IG’s report, SEC Chairman Mary L. Schapiro made the following statement:

Last March, after learning about the Trustee’s suit against the Becker estate, I asked for the Inspector General to look into the matter.

I take his report, which was published today, very seriously.

It would be inappropriate for me to comment on the Inspector General’s referral to the Department of Justice.

I do want to state that I’ve known David for many years to be a talented, highly skilled lawyer and a dedicated civil servant who served under three Chairmen.

As the Inspector General recommends, we will seek another vote of the Commission on the question of the SEC’s position on the valuation of Madoff victim accounts.

I believe that the decision the Commission made on that issue was appropriate under the law and in the best interest of investors.

Moving forward, we plan to implement the other recommendations contained in the report as well.

Of note in Cross’s testimony before the House Financial Services Committee today, as shown in footnote/endnote number 1 to her written testimony, was that Cross has voluntarily recused herself from matters relating to ‘crowdfunding,’ and that Lona Nallengara, Deputy Director of the Division of Corp Fin, would provide testimony on crowdfunding specifically, with Cross providing the remainder of today’s testimony. As explained in the footnote:

 

Ms. Cross’s participation in this testimony does not include matters related to crowdfunding. Prior to joining the Commission staff in June 2009, Ms. Cross served as counsel to a company in connection with its registration under the Securities Act of 1933 of notes offered and sold through its “peer-to-peer” lending platform. Although Ms. Cross has no financial or other interest in her former client or her prior employer, in light of the small number of participants in that market, in order to avoid any appearance concerns, she does not participate in matters involving peer-to-peer lending. Further, since there are some similarities between peer-to-peer lending and some crowdfunding concepts, even though Ms. Cross has been advised by SEC Ethics Counsel that there is no conflict of interest, Ms. Cross has determined that in order to avoid any appearance concerns, she will no longer participate in crowdfunding matters. For purposes of this testimony, Mr. Nallengara will address crowdfunding matters.

 

It appears that Cross’s voluntary recusal from matters relating to crowdfunding (including from providing formal testimony on the matter today), and the related disclosure in footnote 1 of her testimony, reflects an abundance of caution to avoid even the appearance of any potential conflict of interest, particularly in light of the IG’s report and recommendations released yesterday. 

Posted: 9/21/2011 4:27:14 PM by Edith Orenstein | with 0 comments


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Edith Orenstein