Ask FERF about ... SEC Advisory Committee on Smaller Public Companies recommendations.

In its final public meeting on April 20, 2006, the Securities and Exchange Commission (SEC) Advisory Committee on Smaller Public Companies issued its Final Report. Chartered on March 23, 2005, the 21-member committee was formed to assess the current regulatory system for smaller public companies and make recommendations for changes. The committee was directed to consider the applicability of four areas, including the impact of the Sarbanes-Oxley Act of 2002: internal control frameworks, including management's assessment methods and auditing standards; corporate governance and disclosure requirements; accounting standards and financial reporting requirements; and the public-offering process.

The committee made 32 recommendations, assigning each to one of two tiers, to indicate priority. The first primary recommendation is to establish a new system of scaled securities regulation for smaller public companies. Microcap companies, which represent 1 percent of the U.S. equity market, would be defined as those with a market capitalization of less than $128.2 million. Companies with a market cap of $128.2 to $787.1 million (5 percent of the U.S. market) would be considered smallcap.

The measurement of market cap would be self-calibrating and based on a standardized methodology. The new system would provide for clear and firm rules for companies that transition from being a small to a large one and vice versa. The committee believes that the scaled system should be established before the SEC examines whether or not individual regulations should be scaled back.

The most-publicized item relates to recommendations that call for exemptions from Sarbanes-Oxley Section 404 requirements. Microcaps with less than $125 million in annual revenue and smallcaps with less than $10 million in product revenue would be exempt from Section 404 as long as they adhere to the Securities and Exchange Act of 1934 audit committee standards and adopt a code of ethics to comply with Item 406 of Regulation S-K. Relief from external auditor involvement with 404 would also be provided for microcaps with annual revenue between $125 and $250 million and smallcaps with $250 million or less in annual revenues and $10 million or more in annual product revenues.

Based on data from the SEC's Office of Economic Analysis, more than 6,000 companies would receive breaks based on these exemptions. However, should the SEC continue the 404 audit requirement, the committee recommends a more cost-effective auditing standard limited to an external audit of the design and implementation of internal controls.

Currently, a majority of the five SEC commissioners do not support 404 exemptions to the extent provided in the recommendations. Testifying before the U.S. Senate Committee on Banking, Housing, and Urban Affairs recently, SEC Chairman Christopher Cox said his goal "is to find a way to make 404 work. It should not be a question of whether to apply it to companies of all sizes, but how." He said the SEC will work aggressively on implementation with the Public Company Accounting Oversight Board (PCAOB) so that 404's benefits can be derived without needless costs.

Other recommendations include:

* Provide small-business-issuer financial statement and disclosure accommodations to microcap companies. This would allow such companies to provide streamlined or less disclosures on business descriptions, management's discussion and analysis (MD & A), contractual obligations, market risk and executive compensation;

* Allow national exchange-traded companies that have been reporting for at least one year to use Form S-3, Registration Statement Under the Securities Act of 1933, if they are current reporters at the time of filing;

* Adopt policies that encourage and promote dissemination of smaller public company research;

* Adopt a new private offering exemption that does not prohibit general solicitation and advertising, and relax prohibitions against general solicitation and advertising;

* Lead a multi-agency effort to streamline the National Association of Securities Dealers (NASD) registration process;

* Develop a safe-harbor protocol for accounting for transactions that would protect well-intentioned preparers;

* Allow microcaps to apply new Financial Accounting Standards Board (FASB) standards using effective dates for private companies;

* Consider additional materiality guidance for public companies related to previously issued financial statements; and

* Implement a de minimis provision in the application of the SEC's auditor independence rules.

The SEC will not act on the recommendations until after its May 10 roundtable with the PCAOB, which is after press time for this publication. For more detail, visit the SEC and FEI websites.

Cheryl de Mesa Graziano, CPA ([e-mail]), is Vice President, Research and Operations at Financial Executives Research Foundation (FERF).

contributed by FERF