Malone & Bailey, PLLC
December 31, 2002
Jonathan G. Katz, Secretary
Re: File No. S7-40-02, Sarbanes-Oxley - financial experts and independent audit committees
Dear Mr. Katz:
Thank you for the opportunity to comment on the need for a separate regulatory regime for micro-cap companies. Focus on small business regulation has heightened lately from the big company scandals and the resulting recently-enacted Sarbanes-Oxley Act.
I believe I am qualified to write this letter because I am the managing partner of a small public accounting firm that specializes in audits of small public companies. We currently audit about 75 public companies, of which about half are "shells." That ranks us 2nd nationally for audits of public companies not counting the 6 national firms. Our 4 audit partners have substantial experience dealing with public companies, their securities lawyers and marketmakers, and the SEC itself. Public companies represent about 70% of our total practice.
The purpose of this comment letter is to recommend that the Commission develop a different plan to regulate entry-level, development-stage small business issuers by creating a coherent and right-sized regulatory scheme for these issuers.
Small businesses are completely different to regulate than large businesses because:
a) The value of a share of stock in a large business is based on earnings history and analysts' forecasts. Small businesses usually have had no earnings, or an erratic history at best. Small businesses are not covered by major-house analysts. The value of a share of stock in a small business is a purely speculative view by the investor of its market opportunities.
b) Small businesses are served by an entirely different cast of advisors:
- the auditors are mostly different (less than half of small businesses are
audited by the 6 national firms)
- the securities lawyers are completely different
- the analysts are completely different
- the market makers are completely different
This "entirely different" cast of advisors is different for major reasons:
- the required skill set and knowledge base are entirely different,
- such stocks are valued and promoted in an entirely different manner, and
- cost of services is a much bigger factor when auditors audit or lawyers draft disclosures or advise on compliance issues.
In addition, these companies also must depend upon "finders" to help them raise capital because they typically are too small to be served by NASD licensed investment bankers.
c) Small businesses are headed by entrepreneurs. Large businesses are headed by professional managers. They think entirely differently and are motivated differently. Cost of advisory services is again a much larger question for small businesses.
d) Small businesses rarely have their own regulatory compliance expertise - they rely almost wholly on their auditor and securities attorney to guide them. Small company auditors and attorneys have this unique advantage at being able to give comprehensive advice on such matters and expect it to be followed without hair-splitting compliance or disclosure arguments.
The Sarbanes Oxley rules are a "one-size-fits-all" approach to regulation. For example,
- few entrepreneurial CEOs will allow an independent board of directors to tell him anything. He will run the company as he sees fit, regardless of his shortcomings. The investor is betting that he will be able to do so long enough for his idea to be purchased by others (a common exit strategy for small public companies) or for him to pick professional managers to succeed him as the company grows.
- the emphasis on auditor independence to preclude bookkeeping, consulting, and original impairment valuation calculations fits poorly with small business. This "independence" enforcement does little to reduce pressures on the audit account (because the audit fees are always much lower as a percent of firm business, the pressures the big firms face from this one aspect don't exist at the small company level). On the other hand, the costs to the small business of employing 2 sets of accounting professionals are much more significant.
- the "corporate culture" allowing the excesses at Worldcom and Enron couldn't exist at a smaller company. I'm not saying such fraud couldn't occur at small companies, but that if it does, the CEO would have to be at the center every time because almost nothing happens at a small company without the CEO's knowledge and consent.
The reason for mention of the above examples is to illustrate how "big company fixes for big company problems" do little or nothing for small company investor protection except add another layer of cost to the small public companies.
Upper tier market participants are voicing concern in their comment letters about how the upper tier segment of the market can actually make Sarbanes Oxley rules and regulations work in practice. I suggest that until this new regulatory scheme is sorted out by upper tier participants that the small business issuer class be either (a) removed from this round of applying Sarbanes Oxley rules and regulations, or (b) addressed by a different group of regulators that can specialize in small business regulation. When the upper tier knowledge base and practices are developed, the Commission might be in a much better position to focus on creating a coherent and workable set of small business issuer rules and regulations. If a separate group of regulators is in the meantime focusing on small business issues and views, the goals of Congress in implementing an improved regulatory scheme can be made more practical for small businesses.
Small business issuers did not generate the problems that caused Sarbanes Oxley legislation. These problems were caused by upper tier market participants. Therefore, the upper tier should be required to implement Sarbanes Oxley rules and regulations first. Small business issuers deserve the benefit of SEC decision makers developing right-sized regulations for their segment.
The OTC Bulletin Board current lack of membership requirements apart from SEC rules is appropriate for small businesses today. If SEC allows NASD to eliminate OTCBB and add their BBX exchange, I recommend that securities policy makers, regulators and practitioners take this opportunity to step back and create a transition market category for the entry level small business issuer class. From my perspective the Commission will achieve a far better outcome by maintaining a large number of small public issuers being reporting entities than by raising the entry level thresholds so high that meaningful numbers in this issuer class stop being reporting entities.
I recommend that the Commission consider my comments in this letter in a context that considers the benefits of small business issuers currently using SB-2 registrations and OTCBB trading status to raise capital, provide a secondary market for their investors and maintain public reporting status because regulatory oversight requires it. This is a good entry point, base line or transition market from which an entry level small business issuer can develop their company into an exchange quality issuer.
I appreciate the opportunity to comment to the Commission on the proposed rules, and would be happy to discuss any questions the Commission may have with respect to this letter. Any questions about this letter may be directed to me at 713-840-1210 or firstname.lastname@example.org.