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Recommendations of SEC Advisory Committee on Smaller Public Companies1

Scaling Securities Regulation for Smaller Companies

Primary Recommendation

  1. Recommendation II.P.1:
    Establish a new system of scaled or proportional securities regulation for smaller public companies using the following six determinants to define a “smaller public company”:
    • the total market capitalization of the company;
    • a measurement metric that facilitates scaling of regulation;
    • a measurement metric that is self-calibrating;
    • a standardized measurement and methodology for computing market capitalization;
    • a date for determining total market capitalization; and
    • clear and firm transition rules, i.e., small to large and large to small.
    Develop specific scaled or proportional regulation for companies under the system if they qualify as “microcap companies” because their equity market capitalization places them in the lowest 1% of total U.S. equity market capitalization or as “smallcap companies” because their equity market capitalization places them in the next lowest 1% to 5% of total U.S. equity market capitalization, with the result that all companies comprising the lowest 6% would be considered for scaled or proportional regulation.

Internal Control Over Financial Reporting

Primary Recommendations

  1. Recommendation III.P.1:
    Unless and until a framework for assessing internal control over financial reporting for such companies is developed that recognizes their characteristics and needs, provide exemptive relief from Section 404 requirements to microcap companies with less than $125 million in annual revenue, and to smallcap companies with less than $10 million in annual product revenue, that have or add corporate governance controls that include:
    • adherence to standards relating to audit committees in conformity with Rule 10A-3 under the Exchange Act; and
    • adoption of a code of ethics within the meaning of Item 406 of Regulation S-K applicable to all directors, officers and employees and disclosure of the code in connection with the company’s obligations under Item 406(c) relating to the disclosure of codes of ethics.
    In addition, as part of this recommendation, we recommend that the Commission confirm, and if necessary clarify, the application to all microcap companies, and indeed to all smallcap companies also, of the existing general legal requirements regarding internal controls, including the requirement that companies maintain a system of effective internal control over financial reporting, disclose modifications to internal control over financial reporting and their material consequences, apply CEO and CFO certifications to such disclosures and have their management report on any known material weaknesses.
  2. Recommendation III.P.2:
    Unless and until a framework for assessing internal control over financial reporting for such companies is developed that recognizes their characteristics and needs, provide exemptive relief from external auditor involvement in the Section 404 process to the following companies, subject to their compliance with the same corporate governance standards as detailed in the recommendation above:
    • Smallcap companies with less than $250 million in annual revenues but more than $10 million in annual product revenue; and
    • Microcap companies with between $125 and $250 million in annual revenue.
  3. Recommendation III.P.3:
    While we believe that the current costs of the requirement for an external audit of the effectiveness of internal control over financial reporting are disproportionate to the benefits, and have therefore adopted Recommendation III.P.2 above, we also believe that if the Commission reaches a public policy conclusion that an audit is required, we recommend that changes be made to the requirements for implementing Section 404’s external auditor requirement to a cost-effective standard, which we call “ASX,” providing for an external audit of the design and implementation of internal controls.

Secondary Recommendations

  1. Recommendation III.S.1:
    Provide, and request that COSO and the PCAOB provide, additional guidance to help facilitate the assessment and design of internal controls and make processes related to internal controls more cost-effective; also, assess if and when it would be advisable to reevaluate and consider amending AS2.
    5.1 The Commission should ask COSO to provide additional guidance to help management of smaller companies assess internal controls because of the lack of practical guidance and the absence of a standard to enable management of smaller companies to address internal control.

    The Commission could, for example, ask COSO to:
    • add post-year one monitoring guidance with selective testing where appropriate (in this regard, we note that the PCAOB, in its January 17, 2006 comment letter to COSO, noted that “auditability should not be the primary goal of the guidance.”); and
    • emphasize that “materiality” for the purposes of evaluating a “material weakness” is to be determined on an annual but not on a quarterly basis (we note that this might require amendments to AS2 and SEC rules).
    5.2 The Commission should also ask the PCAOB to:
    • address the ability to rely on compensating controls (especially for smaller public companies);
    • describe ways to reduce compliance costs relating to information technology controls, a significant source of internal control compliance costs, consistent with the underlying risks; and
    • provide for smaller public companies:
      • if no external audit of internal control is required, guidance on how management, in general, can assess internal controls efficiently and on a stand-alone (i.e., no external auditor involvement) basis; and
      • if ASX is required, guidance on how management, in general, can assess internal controls efficiently and in satisfaction of the requirements of the external auditor acting under ASX without following the auditor-directed guidance in ASX or AS2.
    5.3 Furthermore, the Commission should provide additional guidance by clarifying considerations, and encouraging cost-effectiveness, relating to management’s design and assessment of internal controls and by developing resources to enhance the availability of additional guidance.
    In order to provide this clarification and encouragement, the Commission could, for example:
    • state that “materiality” for the purposes of assessing a “material weakness” under Section 404 is to be determined on an annual but not on a quarterly basis;
    • note the ability to rely on compensating controls, especially for smaller public companies; and
    • suggest methods to reduce compliance costs relating to information technology controls, a significant source of internal control compliance costs, consistent with the underlying risks.
    In order to develop resources to enhance the availability of additional guidance, the Commission could, for example, allocate resources to develop a free web site with a title such as “Center of Excellence for Reporting and Corporate Governance for Smaller Public Companies.” The web site could contain, for example, best practices, frequently asked questions and complex transaction accounting advice.
  2. Recommendation III.S.2:
    Determine the necessary structure for COSO to strengthen it in light of its role in the standard-setting process in internal control reporting.

Capital Formation, Corporate Governance and Disclosure

Primary Recommendations

  1. Recommendation IV.P.1:
    Incorporate the scaled disclosure accommodations currently available to small business issuers under Regulation S-B into Regulation S-K, make them available to all microcap companies, and cease prescribing separate specialized disclosure forms for smaller companies.
  2. Recommendation IV.P.2:
    Incorporate the primary scaled financial statement accommodations currently available to small business issuers under Regulation S-B into Regulation S-K or Regulation S-X and make them available to all microcap and smallcap companies.
  3. Recommendation IV.P.3:
    Allow all reporting companies on a national securities exchange, NASDAQ or the OTCBB to be eligible to use Form S-3, if they have been reporting under the Exchange Act for at least one year and are current in their reporting at the time of filing.
  4. Recommendation IV.P.4:
    Adopt policies that encourage and promote the dissemination of research on smaller public companies.
    10.1 Maintain policies that allow company-sponsored research to occur with full disclosure by the research provider as to the nature of the relationship with the company being covered. Entities providing such research should disclose and adhere to a set of ethical standards that ensure quality and transparency and minimize conflicts of interest.
    10.2 Continue to permit “soft dollar” payments (i.e., the use of client commissions to pay for research services) under the safe harbor provisions of current Exchange Act Section 28(e), as amplified by guidance set forth in SEC Release No. 34-52635.
  5. Recommendation IV.P.5:
    Adopt a new private offering exemption from the registration requirements of the Securities Act that does not prohibit general solicitation and advertising for transactions with purchasers who do not need all the protections of the Securities Act’s registration requirements. Additionally, relax prohibitions against general solicitation and advertising found in Rule 502(c) under the Securities Act to parallel the “test the waters” model of Rule 254 under that Act.
  6. Recommendation IV.P.6:
    Spearhead a multi-agency effort to create a streamlined NASD registration process for finders, M&A advisors and institutional private placement practitioners.

Secondary Recommendations

  1. Recommendation IV.S.1:
    Amend SEC Rule 12g5-1 to interpret “held of record” in Exchange Act Sections 12(g) and 15(d) to mean held by actual beneficial holders.
    13.1 Do not factor in employee stock options received in compensatory transactions in determining the point an issuer becomes subject to the burdens of a reporting company under the Exchange Act.
  2. Recommendation IV.S.2:
    Make public information filed under Rule 15c2-11.
  3. Recommendation IV.S.3:
    Form a task force, consisting of officials from the SEC and appropriate federal bank regulatory agencies to discuss ways to reduce inefficiencies associated with SEC and other governmental filings, including synchronizing filing requirements involving substantially similar information, such as financial statements, and studying the feasibility of extending incorporation by reference privileges to other governmental filings containing substantially equivalent information.
  4. Recommendation IV.S.4:
    Allow companies to compensate market-makers for work performed in connection with the filing of a Form 211, with full disclosure of such compensation arrangements.
  5. Recommendation IV.S.5:
    Evaluate upgrades or technological alternatives to the EDGAR system so that smaller public companies can make their required SEC filings without the need for third party intervention and associated costs.
  6. Recommendation IV.S.6:
    Make it easier for microcap companies to exit the Exchange Act reporting system.
  7. Recommendation IV.S.7:
    Increase the disclosure threshold of Securities Act Rule 701(e) from $5 million to $20 million.
    19.1 In the alternative, eliminate or modify significantly the financial statement disclosure requirements if (1) options are non-transferable except by law and (2) options may only be exercised on a “net” basis with no employee funds paid to the issuer/employer.
  8. Recommendation IV.S.8:
    Extend the “access equals delivery” model to a broader range of SEC filings.
  9. Recommendation IV.S.9:
    Shorten the integration safe harbor from six months to 30 days.
  10. Recommendation IV.S.10:

    Clarify the Sarbanes-Oxley Act Section 402 loan prohibition.

  11. Recommendation IV.S.11:
    Increase uniformity and cooperation between federal and state regulatory systems by defining the term “qualified purchaser” in the Securities Act and making the NASDAQ Capital Market and OTCBB stocks “covered securities” under NSMIA.
  12. Recommendation IV.S.12:

    Clarify the interpretation of or amend the language of the Rule 152 integration safe harbor to permit a registered initial public offering to commence immediately after the completion of an otherwise valid private offering the stated purpose of which was to raise capital with which to fund the IPO process.
    24.1 Establish a safe harbor from integration for companies that wish to undertake a private placement after they have filed an IPO registration statement and before that registration statement has been declared effective.

  13. Recommendation IV.S.13:
    The SEC should commit more resources and professional staff to an office of ombudsman or “help desk” to provide assistance to smaller public companies. The SEC should also publish guidance on reporting and legal requirements aimed at assisting smaller public companies.

Accounting Standards

Primary Recommendations

  1. Recommendation V.P.1:
    Develop a “safe-harbor” protocol for accounting for transactions that would protect well-intentioned preparers from regulatory or legal action when the process is appropriately followed.
  2. Recommendation V.P.2:
    In implementing new accounting standards, the FASB should permit microcap companies to apply the same extended effective dates that it provides for private companies.
  3. Recommendation V.P.3:
    Consider additional guidance for all public companies with respect to materiality related to previously issued financial statements.
  4. Recommendation V.P.4:
    Implement a de minimis exception in the application of the SEC’s auditor independence rules.

Secondary Recommendations

  1. Recommendation V.S.1:
    Together with the PCAOB and the FASB, promote competition and reduce the perception of the lack of choice in selecting audit firms by using their influence to include non-Big Four firms in committees, public forums, and other venues that would increase the awareness of these firms in the marketplace.
  2. Recommendation V.S.2:
    Formally encourage the FASB to continue to pursue objectives-based accounting standards. In addition, simplicity and the ease of application should be important considerations when new accounting standards are established.
  3. Recommendation V.S.3:
    Require the PCAOB to consider minimum annual continuing professional education requirements covering topics specific to SEC matters for firms that wish to practice before the SEC.
  4. Recommendation V.S.4:
    Monitor the state of interactions between auditors and their clients in evaluating internal controls over financial reporting and take further action to improve the situation if warranted.

1 This list was prepared by the staff of the U.S. Securities and Exchange Commission based on the Final Report of the Advisory Committee. In addition to the recommendations set forth in the text, which are from the body of the Final Report, the Advisory Committee also made the following two recommendations in a letter to SEC Chairman Christopher Cox dated August 17, 2005, which is included as Appendix C to the Final Report:

(1) The Commission [should] further extend . . . compliance dates [for non-accelerated filers to comply with the filing requirements under Section 404 of the Sarbanes-Oxley Act], as follows:

A. A company that is a non-accelerated filer should begin to comply with the management report on internal control over financial reporting requirement and the related registered public accounting firm report requirement in Items 308(a) and (b) of Regulations S-K and S-B for its first fiscal year ending on or after July 15, 2007, instead of its first fiscal year ending on or after July 15, 2006.

B. If necessary, corresponding extensions should also be made to the application of Exchange Act Rules 13a-14(a) and 15d-14(a) as well as to the amended portion of the introductory language in paragraph 4 of the certification required by Exchange Act Rules 13a-14(a) and 15d-14(a).

(2) Smaller public companies [should] not be subject to any further acceleration of due dates for annual and quarterly reports under the 1934 Act; and

In implementing the foregoing recommendation, the Commission should look for guidance in defining the term “smaller public company” to the definition of that term adopted by the Advisory Committee, by a vote of 14 to 0 with one abstention, as an internal working definition to provide an umbrella definition under which the Advisory Committee’s four subcommittees can bring forth recommendations that are meaningful for their specific purposes.



Modified: 09/07/2007