ATTORNEY: JOSHUA B. SILVERMAN
POMERANTZ MONITOR MARCH/APRIL 2017
Tucked away in the latest Dodd-Frank reform bill is a provision that threatens to roll back crucial
investor protections for nearly a third of public companies. House Financial Services Committee
Chair Jeb Hensarling’s proposal, called CHOICE 2.0, would exempt all companies with market capitalization below $500 million, and all depository institutions with assets below $1 billion, from auditor review of internal controls. Currently, only the smallest companies – those with market capitalization below $75 million – are exempt from the requirement.
The auditor attestation requirement of Section 404(b) of the Sarbanes-Oxley Act of 2002
serves an important purpose. It helps to identify deficiencies in internal controls over financial
reporting, so that companies can fix those deficiencies at an early stage. Expanding the Section 404(b) exemption to $500 million would increase the number of exempt companies approximately eight-fold. The proposed expansion would also exempt some constituents of common market indices like the Russell 2000 and Russell 3000 from auditor review of financial controls.
While all companies that have been public for more than one year are required to have management attest to the sufficiency of internal controls, repeated academic studies show that the auditor review under Section 404(b) is far more effective. The studies demonstrate
that companies exempt from auditor attestation have a higher rate of accounting irregularities and restatements than those subject to the Section 404(b) requirement. Moreover, a review by the Government Accounting Office, required under Dodd-Frank, determined that compliance with Section 404(b) has a positive impact on investor confidence in the quality of financial reports. A recent analysis from MarketWatch’s Francine McKenna shows that the concern is more than academic. It found that approximately 11.4% of the non-bank companies that received an auditor internal control over financial reporting opinion in 2015 but would be exempted by Hensarling’s bill reported ineffective internal controls. 8.6% of the banks that would be exempted had control deficiencies. If CHOICE 2.0 is implemented,
investors would not learn of these problems until it was too late.
The measure’s proponents incorrectly claim that removing the requirement will increase initial public offerings of small and mid-market companies. This is a red herring. Newly-public companies are not subject to the requirements of Section 404(b). Regardless of market
capitalization, no company needs to provide a Section 404(b) auditor attestation at the time it goes public, or even with its first annual report as a public company on SEC Form 10-K. The auditor attestation is only required after a company has already filed a full years’ worth of
periodic reports as a public company. Moreover, as an SEC study has determined, the cost to comply with Section 404(b) has declined significantly.
Nor does the broader regulatory environment justify stripping this important investor protection. Scores of recent measures such as the JOBS Act and Regulation A+ have already slashed red tape for small and middle market companies seeking to tap public markets.
Companies choosing to remain private do so largely because they can easily raise money from private equity firms and lenders, not because current regulatory burdens are excessive.
When a proposal was introduced in 2014 to expand the Section 404(b) exemption to only $250 million, the Center for Audit Quality and the Council for Institutional Investors warned in a joint letter to the House Financial Services Committee that the assurance provided under
that statute was “an important driver of confidence in the integrity of financial reporting and in the fairness of our capital markets.” The expansion proposed today is twice as large, and would cause an even greater threat to investor confidence and accounting integrity.