SEC to Vote on 404(b) Exemptions

Well, here we go: the Securities and Exchange Commission will vote next week on a proposal to exempt companies with less than $100 million in annual revenue from audits of their internal control over financial reporting. 

The meeting will happen on March 11, and so far the internal control exemption is the only item on the agenda. 

This day has been a long time coming. SEC chairman Jay Clayton has made no secret of his desire to exempt more companies from internal control audits, which are required under Section 404(b) of the Sarbanes-Oxley Act. Since he has two other Republican commissioners who also dislike the rule, and only one Democratic commissioner who presumably would lean against, the final outcome seems like a foregone conclusion.

The proposal, first unveiled last May, would let public companies with less than $100 million in annual revenue skip those 404(b) audits — mostly as a favor to biotech firms, which often go public to raise capital but don’t see revenue for many years while they develop their drug compounds. Those firms can then fall into a scenario where they have a relatively large market cap but no significant revenue, and they’re spending precious capital on audits of internal control. 

Non-accelerated filers (those with market cap below $75 million) have always been exempt from 404(b) audits. Larger companies would still be subject to 404(b) audits as usual. 

Moreover, none of this would change compliance with Section 404(a), which requires companies to offer their own assessment of ICFR. Section 404(a) has always been the law of the land for everyone, non-accelerated filers included. 

Aside from the wet kiss to the biotech industry, Clayton & Co. also say the cost of Section 404(b) compliance is a heavier burden for small companies, and therefore drives startup businesses away from going public. 

It is true that small companies devote a bigger share of their revenue to audit fees than large companies do; and that the percentage of revenue they spend on fees has risen over the years. Then again, the increase in audit fees is mostly due to the complexity of new accounting standards that have arrived over the last decade — not because auditors are somehow more nit-picky over internal control today than they were circa 2007.

There’s also the fact that filers exempt from ICFR audits are more likely to experience financial restatements and other financial reporting than companies that are 404(b) compliant. So as much as Clayton and fellow SOX critics might complain about excessive costs of compliance, they seem remarkably silent about the benefits of SOX compliance in the form of more reliable financial statements to investors. 

Plus, as I’ve noted ad nauseam on this blog, IPOs are dwindling in this country and around the world mostly because the private markets are more compelling. So even if we waved away 404(b) audits for everyone, it’s not like the IPO market will zoom back to the heady days of dot-com mania in the late 1990s.

You get the idea. Exemptions from 404(b) audits are a solution in search of a problem. That won’t stop Clayton and fellow Republicans from ramming through their proposal anyway.