Mar 20, 2020

Small Public Companies to Cut Audit Costs Following New SEC Rule Limiting Auditor Attestation

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Small publicly traded companies will be facing easier audit requirements following the new Securities and Exchange Commission (SEC) rule adopted on March 12, 2020. Section 404 of the Sarbanes-Oxley Act requires public companies’ annual reports to include the company’s own assessment of internal control over financial reporting, as well as an outside auditor’s attestation of such internal control over financial reporting. The newly adopted SEC rule exempts public companies with annual revenue below $100 million and a public float of less than $700 million from such auditor attestation requirement.

Prior to such amendment, Section 404(a) and 404(b) of the Sarbanes-Oxley Act of 2002 (SOX) required a publicly-held company’s auditor to attest to management’s assessment of its internal controls and include a report from management on the effectiveness of the company’s internal control over financial reporting.

The adoption of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) in 2010, relieved smaller public companies with some of the burden from SOX auditor attestation.  The 2010 adoption of a new Section 404(c) of SOX exempted public companies that are not “accelerated filers” or “large accelerated filers” (as defined in Rule 12b-2 under the Securities Exchange Act of 1934) from the auditor attestation requirement of Section 404(b). The new rule adopted last week provided even further relief for smaller public companies by changing  the definitions of “accelerated filer” and “large accelerated filer” to expand the number of issuers that qualify as “non-accelerated filers” and are thus not required to obtain such outside auditor attestation of their internal control over financial reporting.

Companies have been advocating for such changes since the initial outside auditor attestation requirements have been put in place. Advocates’ main argument was that imposing less auditing requirements will decrease financial burden on small public companies which in turn will allow them to allocate more time and funds into their business and product development.

One advocate, Damian Finio, Chief Financial Officer of Teligent, Inc., a specialty generic pharmaceutical company with annual revenues of less than $100 million and a public float of less than $250 million, in a comment letter sent on July 23, 2019 in respect of these amendments prior to their adoption, wrote that such rule will “benefit small public companies and their investors by freeing up more capital to hire talent, invest further in research and development, and expand our product pipeline to improve our ability to develop high quality and competitive products to treat the nation’s most dire public health concerns.”

SEC Commissioner Hester Peirce said in a statement supporting such advocates’ claims, that: (a) “A company trying to develop a vaccine for a fast-spreading virus, something that is now on all of our minds, will be able to pour resources and—importantly—management’s time and attention into that effort rather than into obtaining an internal controls audit”; and (b) that she is  “encouraged by indications in the comment file that the amendments will enable, for example, biotech companies to invest more in research and development and community banks to make more loans to local businesses.”

This SEC’s decision is part of a broader effort to encourage more companies to raise money in public markets by easing regulations. The SEC estimates that 373 companies will be covered by the change. However, such change has previously faced with concerns over such companies having accounting issues such as erroneous earning reports or weaknesses in internal controls over financial reporting, including in in the case of Teligent, Inc. and other companies issuing comment letters.

The vote to approve the change was 3-1, with the commission’s sole Democrat, Allison Herren Lee, dissenting. According to Commissioner Lee’s dissent, the rule was adopted “in the face of extensive objection from investors”, and the SEC shall “strip away a layer of investor protection for financial reporting.”

In an argument against SEC’s new rule, Commissioner Lee claimed that “the final rule rests in part on the unsupported hypothesis that relieving companies of modest additional costs for auditor attestation will encourage more companies to go public”, but “there just isn’t evidence for this intuition, which animates a number of other recent policy choices”. In addition, Commissioner Lee said that the rule will lead to “less information for investors about the quality of internal controls, less detection of ineffective internal controls, and less accountability for management regarding its assessment of internal controls.”

In a statement, SEC Chairman Jay Clayton said the new rule is aimed at small, low-revenue companies “for whom the cost of unnecessary regulation is most acute.” Mr. Clayton said executives must still certify that they have evaluated and disclosed the effectiveness of their internal controls, and companies will still be required to hire an independent auditor to examine financial statements.

This new SEC rule is just one of many regulatory changes that have been adopted over the past few weeks in an effort to stimulate business activity through the reduction of regulation.  It remains to be seen what effect such rule might have in stimulating small public companies to find a cure to the coronavirus, but more realistically, whenever things resume to normal, this change will cause a meaningful regulatory reduction for small public companies with annual revenue below $100 million and a public float of less than $700 million.

If you have questions about this legal alert, please contact your SGR Securities Counsel.

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