[House Hearing, 109 Congress]
[From the U.S. Government Publishing Office]
SARBANES OXLEY SECTION 404: WHAT IS THE PROPER BALANCE BETWEEN INVESTOR
PROTECTION AND CAPITAL FORMATION FOR SMALLER PUBLIC COMPANIES?
=======================================================================
HEARING
before the
COMMITTEE ON SMALL BUSINESS
HOUSE OF REPRESENTATIVES
ONE HUNDRED NINTH CONGRESS
SECOND SESSION
__________
WASHINGTON, DC, MAY 3, 2006
__________
Serial No. 109-51
__________
Printed for the use of the Committee on Small Business
Available via the World Wide Web: http://www.access.gpo.gov/congress/
house
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COMMITTEE ON SMALL BUSINESS
DONALD A. MANZULLO, Illinois, Chairman
ROSCOE BARTLETT, Maryland, Vice NYDIA VELAZQUEZ, New York
Chairman JUANITA MILLENDER-McDONALD,
SUE KELLY, New York California
STEVE CHABOT, Ohio TOM UDALL, New Mexico
SAM GRAVES, Missouri DANIEL LIPINSKI, Illinois
TODD AKIN, Missouri ENI FALEOMAVAEGA, American Samoa
BILL SHUSTER, Pennsylvania DONNA CHRISTENSEN, Virgin Islands
MARILYN MUSGRAVE, Colorado DANNY DAVIS, Illinois
JEB BRADLEY, New Hampshire ED CASE, Hawaii
STEVE KING, Iowa MADELEINE BORDALLO, Guam
THADDEUS McCOTTER, Michigan RAUL GRIJALVA, Arizona
RIC KELLER, Florida MICHAEL MICHAUD, Maine
TED POE, Texas LINDA SANCHEZ, California
MICHAEL SODREL, Indiana JOHN BARROW, Georgia
JEFF FORTENBERRY, Nebraska MELISSA BEAN, Illinois
MICHAEL FITZPATRICK, Pennsylvania GWEN MOORE, Wisconsin
LYNN WESTMORELAND, Georgia
LOUIE GOHMERT, Texas
J. Matthew Szymanski, Chief of Staff
Phil Eskeland, Deputy Chief of Staff/Policy Director
Michael Day, Minority Staff Director
(ii)
C O N T E N T S
----------
Witnesses
Page
Wander, Mr. Herbert S., Chairman, SEC Advisory Committee on
Smaller Public Companies....................................... 4
Broderick, Mr. Bill, Chief Financial Officer, Analytical
Graphics, Inc.................................................. 6
Crandell, Mr. Keith, Managing Director, ARCH Venture Partners.... 9
Neiss, Mr. Woodie, Chief Financial Officer, FLAVORx, Inc......... 11
Schroeder, Mr. Mark, President/CEO, German American Bancorp...... 13
Burns, Mr. James, President & CEO, EntreMed, Inc................. 15
Appendix
Opening statements:
Manzullo, Hon. Donald A...................................... 27
Velazquez, Hon. Nydia........................................ 28
Prepared statements:
Wander, Mr. Herbert S., Chairman, SEC Advisory Committee on
Smaller Public Companies................................... 30
Broderick, Mr. Bill, Chief Financial Officer, Analytical
Graphics, Inc.............................................. 54
Crandell, Mr. Keith, Managing Director, ARCH Venture Partners 59
Neiss, Mr. Woodie, Chief Financial Officer, FLAVORx, Inc..... 67
Schroeder, Mr. Mark, President/CEO, German American Bancorp.. 76
Burns, Mr. James, President & CEO, EntreMed, Inc............. 84
(iii)
SARBANES OXLEY SECTION 404: WHAT IS THE PROPER BALANCE BETWEEN INVESTOR
PROTECTION AND CAPITAL FORMATION FOR SMALLER PUBLIC COMPANIES?
----------
WEDNESDAY, MAY 3, 2006
House of Representatives
Committee on Small Business
Washington, DC
The Committee met, pursuant to call, at 2:00 p.m., in Room
2360 Rayburn House Office Building, Hon. Donald Manzullo
[Chairman of the Committee] presiding.
Present: Representatives Manzullo, Bartlett, Kelly, Akin,
Velazquez, Davis, Barrow, Moore.
Chairman Manzullo. Good afternoon. The hearing today will
analyze the impact of Sarbanes Oxley on our nation's smaller
public companies. In particular, this hearing will focus on
Section 404 of SOX. Your White Sox, which are causing the most
headaches, well, Herb is from Chicago.
Mr. Wander. And a White Sox fan.
Chairman Manzullo. And a White Sox fan. You don't want to
wait another 100 years, Herb.
In particular, the hearing will focus on Section 404 of
SOX, which is causing the most headaches and expense for our
Nation's smaller companies.
In 2002, Congress passed with my support the Sarbanes Oxley
Act, or SOX. Ms. Vel zquez and I both serve on the Finance
Committee.
This legislation was a response to corporate scandals at
the large companies, such as Enron and WorldCom. However,
changes made by SOX applied equally to all public companies,
regardless of size.
One of these changes was to perform annual testing of
internal control under SOX Section 404. These tests require
company's management to evaluate whether internal controls are
adequate and require an independent auditor to sign off on
management's assessment.
Shortly after SOX passed, the SEC estimated in regulations
that compliance with Section 404 would cost companies around
$90,000 annually. However, the expected costs in reality did
not match up. In reality, public companies are paying well in
excess of $1 million annually to comply with this mandate.
To its credit, the SEC recognizes that strict compliance
with Section 404 may not be beneficial for smaller public
companies. This is why the SEC has delayed implementation of
this provision for companies with market values under $75
million until July of 2007.
In addition, in March 2005 the SEC convened the Advisory
Committee to Small Public Companies to analyze the effects of
this and other SOX provisions on small companies. This panel
was also tasked with making recommendations to the SEC on what
should be done to help our smaller public companies cope with
the burdens of SOX.
The Advisory Committee released its final report last week.
In the report, the Committee recommends that companies with
market values of less than $128 million be exempt from Section
404 unless and until corporate auditing standards are
established for these companies. While, SOX technically applies
only to public companies, private companies have plenty of
reasons to be nervous. The ability to gain access to public
markets now turns on whether they can stomach the huge costs of
Section 404.
As the witnesses will discuss today, many are just
rejecting the public markets and staying private. Clearly, SOX
has an important purpose, however the legislation must not be
allowed to overly burden our smaller companies.
Today we will hear testimony on the compliance burdens SOX
Section 404 has created for our smaller public companies, and
explore whether the recommendations of the SEC Advisory
Committee will fix these problems. I look forward to hearing
the testimony today, and now yield to the Ranking Minority
Member, Representative Vel zquez of New York, for her opening
comments.
[Chairman Manzullo's opening statement may be found in the
appendix.]
Ms. Vel zquez. Thank you, Mr. Chairman.
This hearing to review the recommendations of the SEC's
Advisory Committee has been a long time coming. Small
businesses continue to face barriers that hinder their ability
to remain competitive and strong.
The sky-rocketing costs of health insurance and start-up
capital pose many challenges for entrepreneurs. Both soaring
regulatory and compliance burdens have consistently been one of
their number one concerns.
Almost every single small business owner and association
that has testified before this Committee has put reducing the
regulatory burden at the top of their list for legislative
package. That is not different with the Sarbanes Oxley Act, as
Democrats on the Committee have been hearing from small
business owners for nearly two years now. Unfortunately, the
situation does not seem to be getting any better.
The Sarbanes Oxley Act was intended to strengthen the
corporate governance practices of the business community. But,
what we have heard is that this one comes with a cost, and a
particularly steep cost at that.
The auditing standards, disclosure requirements, and
corporate governance rules of the Act have added significantly
to the operating costs of small companies, many who have gotten
stuck in the fray.
Democratic members of the Committee held a roundtable back
in October, so that we could hear directly from the small
business community on the impact of these reforms. A number of
small firms we spoke with agree that it is difficult not to
support the intentions of Sarbanes Oxley, most notably strong
corporate governance and shareholder accountability. Yet, for
the 14,000 publicly traded companies, the majority of which are
smaller firms, Section 404 of the Act poses a great burden to
their future economy vitality. Numerous stories and surveys
point to the staggering compliance costs of Section 404 as a
major burden on small companies.
In June, 2003, the SEC estimated the cost of implementing
Section 404 on all registrants at almost $1.24 billion or
$91,000 per registrant. Yet, time has told that the SEC vastly
underestimated its calculations. Recent surveys show that the
small companies are paying an average of nearly $1 million to
comply with Section 404, and this is simply unacceptable.
Even though some studies show these costs have declined,
they are still significant and are bearing a disproportionate
burden on small firms.
The complying costs of Section 404 for small companies is
approaching 3 percent of revenue, while it is less than 1/10th
of 1 percent for larger companies.
Adding to concerns this new evidence showing numerous small
companies suffering under the weight of costly regulations have
begun to look abroad to go public. There are currently 37 U.S.
companies listed on the AIM by the London Stock Exchange, 19
companies alone that have been listed within the last year.
This so-called Sarbanes Oxley free zones have freed some
small firms from the strict capital market regulations seen
here in the U.S. Both Sarbanes Oxley and Section 404 have been
cited as primary drivers in this development, which are, in
turn, hurting the American economy.
Clearly, there is no end in sight to the burden that so
many of our Nation's small firms are forced to face. My
Democratic colleagues and I have cited many of these concerns
in two recent common letters to the SEC. I am pleased, though,
with the work the SEC Advisory Committee has done toward
finding a solution that truly eases the burden and provides
relief for small companies.
With the recent release of the Committee's recommendations,
I am hopeful this will become the basis for a real regulatory
reform proposal. I know that much uncertainty surrounds the
SEC's review and consideration of the Advisory Committee's
recommendations. However, this situation is resolved, I urge
the SEC to address the issue straight on and provide smaller
companies with definitive relief from Section 404 sooner rather
than later.
I look forward to the testimony of the witnesses today.
Thank you, Mr. Chairman.
[Ranking Member Velazquez's opening statement may be found
in the appendix.]
Chairman Manzullo. And, thank you, Ms. Vel zquez.
Some of the ground rules, we have a system of lights up
there. Green is go, yellow is you got a minute to go, and red
you are supposed to stop. This is not used in case you don't
stop, okay?
It's important to tell your own story. The complete written
statements of the witnesses will be made part of the official
record, so you don't have to worry that if you miss something
it won't be included in it. I'm going to keep the record open
for three weeks for anybody else that wants to submit written
statements, but they cannot exceed two written pages. No tomes,
okay? And, the print cannot go below 10 points. So, no footnote
prints, for anybody else who wants to submit additional
statements, including obviously members, we'll keep it open for
that.
Now, we are expecting votes, and having taken the
Constitutional Oath to vote. When the bell goes off, we will go
out and vote. I think there are three votes and that will take
probably about a half an hour. Votes are anticipated any
minute. But what we'll do is, we'll start first with Mr. Wander
and then, what I don't want you to do is to spend so much time
looking at the clock that you don't concentrate on your
testimony.
How many here have not testified before Congress before?
Oh, my goodness, four out of six. Okay. Well, the other two
just assure them, you know, that nothing is going to happen,
and this is a very, very serious subject, and it's unusual to
get involved in something this esoteric, but sometimes the
small businesses want to get larger. There are many companies
that come within the SBA definition of small businesses, that
is less than 500 employees, and in the aerospace industry less
than 1,500 employees, that will be in this situation.
So, Mr. Wander, we will start with you. I look forward to
your testimony. You might want to pull the mike as close to
your mouth as you can.
Thank you.
STATEMENT OF HERB WANDER, SEC ADVISORY COMMITTEE ON SMALLER
PUBLIC COMPANIES
Mr. Wander. Thank you, Mr. Chairman. It's a delight to be
here this afternoon, and I thank you for this opportunity to
provide oral testimony, as well as my written statement.
Who am I? I'm Herb Wander. I am just recently released from
my obligations as Co-Chair of the Securities and Exchange
Commission's Advisory Committee on Smaller Public Companies. We
were established 13 months ago, have gone through a very
extensive fact-finding process, and submitted our report to the
Securities and Exchange Commission last Sunday, April 23rd. I'm
also a partner with the national law firm of Katten Muchin
Rosenman LLP.
In my written statement, so I don't have to repeat it,
contains information concerning the mission of our Advisory
Committee, the overarching principles we follow, lists the
diverse membership, indicates to you all the extensive
information gathering process that we went through, both in
hearings and asking written requests, and then there are a
total list of our recommendations, which, by the way, go beyond
Section 404. However, this afternoon I will only talk about
404, dealing with internal controls.
As both the Chair, and as indicated, the original estimates
of the cost of Sarbanes Oxley, starting with the Senate Report
on Sarbanes Oxley, indicated that they thought there would be
no increase in auditing costs, have been far off the mark. And
so, I am not going through that, I think that's been well
documented, I will only add that the latest study that the Big
Four Accounting Firms produced two or three weeks ago by the
Charles River Associates indicated that some of the fees are
coming down, but they still approach $900,000 to a million
dollars for smaller public companies, which in many cases gets
to be double digit percentages of their cash flow. So, it is
truly a big cost, and, indeed, that study also noticed that
total auditing costs, that's both 404 and regular auditing
costs were relatively flat, having gone up 200-300 percent over
the last three or four years, so that the cost burden is
enormous and that's well documented and I don't think disputed
by anybody.
We should not forget the fact that, not only have the costs
up, but it's the opportunity costs, it's where do you spend
your money, do you spend your money on research, and my
colleagues who will testify I think are far more qualified to
talk to you about loss of opportunity costs and the costs this
puts on them.
So, I would like to now concentrate on, essentially, our
recommendations, because I think there's ample evidence in the
record, and after our 13 months I think that it's well
documented. I want to emphasize the following points. Our
Advisory Committee was not here to repeal 404, but to fix it.
It is clear that internal controls have been controlled since
1977. We think they are important, but they have to work
properly for all companies, particularly for smaller companies.
Our recommendations which you read are crafted very
carefully, and you must read them very carefully. We say,
``Unless and until a framework for assessing the 404 that works
for assessing internal controls over financial reporting for
smaller public companies is developed that recognize their
characteristic needs.'' So, what we are saying is, it's time
now to get it right, before all those companies that you
indicated in your opening remarks will become subject to this,
that they don't have to go through something that everybody in
today's world admits needs a major overhaul. So, we are not
saying just totally exempt everything. We have put conditions
on everything, and we say we would like to fix it.
I also want to mention that none of the critics, Arthur
Levitt, Lynn Turner, all of the critics, really do admit that
there are faults, and serious faults, with 404. So the question
is, how do we fix it, not whether we let it continue to
operate, and hope that it gets fixed all of a sudden.
We also want to emphasize that while we are talking about a
large number of companies under our recommendations, they
comprise less than 5 percent of the total U.S. market
capitalization. People have bandied around, you would exempt 80
percent of the public companies. Actually, the number is 70
percent, but the fact is that these are the smallest
capitalization, under 5 percent of total market capitalization.
We also believe very strongly that we think AST2, which is
Accounting Standard No. 2 adopted by the PCAOB needs fixing.
The PCAOB has done a good job in trying to provide guidance, as
well as the SEC providing guidance. The guidance has just not
worked, and we think they ought to go back to the drawing board
and make changes to the regulation, because those who are
applying it look at the rule and they look at the guidance
secondarily or not at all.
Chairman Manzullo. How are you doing on time?
Mr. Wander. Well, I'm reminded of the story that the
Securities Act of-
Chairman Manzullo. No, on time, you are out of time.
Mr. Wander. I'm on time, all right. I would just like to
close that I think my written statement contains all of the
necessary information concerning our recommendations, which we
think should be and, in fact, can be adopted by the SEC and the
PCAOB.
Thank you very much.
[Mr. Wander's testimony may be found in the appendix.]
Chairman Manzullo. Thank you very much.
Our next witness is Bill Broderick, Chief Financial Officer
and Treasurer of Analytical Graphics, Incorporated. We look
forward to your testimony.
STATEMENT OF BILL BRODERICK, ANALYTICAL GRAPHICS, INC.
Mr. Broderick. Good afternoon. My name is Bill Broderick.
I'm the Chief Financial Officer for Analytical Graphics, a
software company based in Exton, Pennsylvania, serving the
national security industry. I also serve as a Board Member of
the Small Business and Technology Council.
Chairman Manzullo, Congressman Vel zquez, and Members of
the Committee, I would like to thank you for holding this
hearing and the opportunity to testify.
In the short time we have, I hope to provide some
highlights on my prepared statement in regards to the
unintended consequences of SOX and small public companies, and
how it has affected my company, my small private company.
Since 1989, AGI has grown to a 250-person company, and has
been named Best Small Company to Work For in America for 2004
and 2005.
Chairman Manzullo. Bill, I'm going to restart your clock
when we get back. How does that sound?
Mr. Broderick. That's okay, Mr. Chairman.
Chairman Manzullo. All right? Because I don't want to have
people walking out in the middle of your testimony. That
doesn't look too good, does it?
So, we are going to recess for about a half an hour and
then we'll be right back.
Is there anybody here on the panel that has to catch a
plane later on this afternoon? Okay, then we'll keep this
order.
[Recess.]
Chairman Manzullo. I'm waiting for the alarm clock to reach
6:00 a.m., and then for somebody to smash the alarm clock and
to go looking for groundhogs.
So, Mr. Broderick, if you would like to start all over
again, and you may have been through this before.
Mr. Broderick. Yes, I have been, Mr. Chairman.
Chairman Manzullo. For about 40 seconds, is that correct?
Mr. Broderick. Yes.
Chairman Manzullo. So, if I ask you if you've ever
testified before Congress before you can say yes now. We look
forward to your testimony.
Mr. Broderick. I have on the House Armed Services side, Mr.
Chairman.
Okay, thank you again for this hearing, Mr. Chairman. I'm
just going to pick up where I left off with some company
background.
Since 1989, AGI has grown to a 250-person company and has
been named the Best Company to Work in America for 2004 and
2005. Over our history, we have been able to assemble a
talented team of 140 engineers and scientists to provide a
unique and innovative product line, with 12 issued patents to
our credit. We are proud that the national security community
relies on the fidelity of our software in many critical areas,
such as providing battle space situational awareness for
efforts in Afghanistan and Iraq, as well as the Pentagon for
top level-
Chairman Manzullo. Well, just a second, you sound like a
guy doing a trailer in one of those ads, all right? You can
slow down a little, all right?
Mr. Broderick. I'm just -
Chairman Manzullo. Don't worry about it, all right?
Mr. Broderick. Okay-as well as top level briefings in the
Pentagon.
The key question I pose for today's hearing is, given the
disproportional cost of Section 404 on SOX, on small public
companies, are we building a safeguard that costs orders of
magnitude more than any proven benefit, or simply put, are we
being penny wise and pound foolish with respect to small
business compliance with SOX?
As cited in the April, 2006 final report of the Advisory
Committee on Smaller Public Companies, the discrepancy between
the initial Section 404 cost estimate of $91,000 versus the
actual cost of $900,000 raises the question of cost benefit for
the shareholders of smaller public companies.
Given the ongoing cost of compliance with Section 404, the
valuations of smaller public companies are permanently
impacted. In my prepared statement, I provided you with a macro
level calculation on this impact, which resulted in an on
average loss of approximately $8.1 million in shareholder value
for each smaller public company, or approximately $60 billion
in total equity valuation loss would be incurred on a permanent
basis across all smaller public companies.
In addition, the above figures do not include the
opportunity costs and lost productivity of management and other
personnel related to core business activities. Because the
regulations lack cost benefit analysis and professional
judgment, investors lose significant shareholder value.
We fully concur that regulatory reforms were needed in the
wake of the financial collapses and malfeasance at Enron and
other companies. However, there appears to have been a rush to
enact sweeping reform, without a basic cost benefit analysis to
assess the impact on smaller public companies.
As discussed in my prepared statement, we eliminated the
option of going public to liquidate our venture investor,
primarily from the significant burdens associated with SOX
compliance, which would not only reduce our profitability due
to the cost of SOX, but divert senior management time away from
core business activities.
Therefore, we were forced to raise $15 million in bank debt
and used $13 million of our own cash to liquid out our venture
investors entire holdings. Accordingly, the result and effects
of AGI being unable to effectively access the public capital
markets are as follows;
1. Our limited capacity to make investments in advanced R&D
affects our ability to deliver unique capabilities for national
security needs, which is important, not only to stay
competitive in a marketplace dominated by large prime
contractors, but also to keep our Nation's defense technology
far ahead of our adversaries.
2. We have foregone growth opportunities and investments in
business development, marketing and sales to the detriment of
our long-term sustainability.
3. Limited cash reserves put a strain on existing business
operations, preventing scaling up of our infrastructure, which
includes financial systems, internal controls, and information
technology.
Our recommendations to reduce the disproportional impact of
the Sarbanes Oxley Act on smaller public companies are
summarized as follows;
First, AGI strongly supports the Advisory Committee's
primary recommendations, especially the establishment of a new
system of scaled or proportional securities regulations for
smaller public companies.
Second, I cannot emphasize this enough, the proper tone at
the top is a critical enabler and force multiplier for
acceptance of applicable internal controls throughout an
organization. To this end, AGI recommends mandated executive
level professional education to establish understanding and
commitment to the importance of effective internal controls.
Internal controls are best implemented with the right tone from
top down.
Third, in reference to the Advisory Committee
recommendation III(P)(1), AGI recommends that not only the CEO
and CFO provide certification for internal controls, but also
the Chief Operating Officer or equivalent operations executive
should provide certification as well. This executive is key to
adoption of an effective internal control system, since he or
she is more intimately involved in the day-to-day departmental
operations. This key executive should be held accountable and
not be disconnected from the internal control certification.
In closing, if the status quo remains, this will reinforce
a message to non-public small companies that you must be a
larger company to access the public capital markets, and many
smaller public companies, especially in the micro category, may
be forced to go private.
I applaud the SEC for establishing an Advisory Committee to
examine these matters, and commend the Advisory Committee on
their diligent comprehensive efforts to provide a framework to
establish common sense, proportional regulations under a cost
benefit structure.
I'm grateful to this Committee for holding this hearing on
topics vital to the health of small business and the
opportunity to testify.
I welcome your questions and thank you.
[Mr. Broderick's testimony may be found in the appendix.]
Chairman Manzullo. Thank you very much.
Our next witness is Keith Crandell, Co-Founder and Managing
Director of ARCH Venture Partners. We look forward to your
testimony.
STATEMENT OF KEITH CRANDELL, ARCH VENTURE PARTNERS
Mr. Crandell. Thank you very much, Mr. Chairman, and
Members of the Committee, good afternoon.
I am Keith Crandell, Co-Founder and Managing Director of
ARCH, a 20-year old venture capital firm located in Chicago,
Illinois. We fund primarily seed and early stage companies in
the technology and life sciences area. My partners and I sit on
many boards of both public and private companies.
I'm here today in my capacity as a Board Director for the
National Venture Capital Association, which represents more
than 400 venture capital funds in the U.S. U.S. companies
originally funded with venture capital, such as Genentech,
Goggle, Archipelago, now represent 10 percent of the annual GEP
and employment in the United States.
I want to speak today on behalf of our country's emerging
growth companies, which are being stifled by the Sarbanes Oxley
law, specifically, Section 404. This law has drained capital
and resources from these young companies, distracted management
from growing businesses, diverted the major members of the
accounting profession, and threatened the future of the U.S.
capital market system for growth businesses.
Profitability is critical on Wall Street, and Sarbanes
Oxley attacks profitability head on. The cost of complying with
SOX 404 at small companies approaches a million dollars a year.
If one assumes a healthy company can achieve 10 percent net
income, then SOX dictates that such a company would have to
garner up to $10 million in additional revenue just to support
the cost of compliance.
For those who suggest that the cost of 404 compliance will
eventually fall, I would argue that without dramatic change the
numbers will not fall enough. A recent CRA international study
found that even with a 31 percent drop in SOX compliance costs
last year, small cap companies still on average bear a SOX
burden of $860,000. It's highly unlikely that SOX costs will
continue to drop as precipitously in the future, and the costs
remain excessive.
Of equal concern is the drain on human resources to achieve
SOX 404 compliance. These companies are being placed in an
undesirable position of having to hire additional financial
staff and forego hiring engineers and sales teams. These hires
do not foster company growth.
To exacerbate the situation, SOX has compelled the Big Four
auditors I'm familiar with to shift their focus from auditing
companies of all sizes to leveraging lucrative 404 practices at
large corporations. As a case in point, I served as a Board
Member on a small cap public company that was informed by their
Big Four auditor in 2004 that, not only were they too busy with
their larger clients to complete the company's audit on time,
but that their audit would cost 16 percent more than the
previous year. The Big Four auditor provided - suggested that
the smaller company release its numbers late, which we all
know, including the auditor, that that would be public market
suicide.
Although many have suggested that small companies turn to
second and third tier accounting firms, this isn't a realistic
choice for many ventured-backed companies, since most
investment banks that are willing to take their companies
public request that the company use a Big Four firm.
From a macro economic perspective, SOX 404 has contributed
significantly to a clog in the IPO pipeline in the United
States. The cost of the legal and accounting work for initial
public offering processes stands at close to $2 million, up
from $500,000 a few years ago. These hurdles to go public in
the U.S. today are driving venture capital-backed companies
away from our capital market system to other exits and other
markets.
In 2005, only 56 venture-backed companies went public on
U.S. exchanges. The healthy IPO market historically has been at
least twice that level. Only ten IPOs for ventured-backed
companies were accomplished in the first quarter of this year,
so we are on track for another dismal year for IPOs.
We are seeing pre-IPO companies now embrace two viable
alternatives to going public in the U.S. First is the
preference for acquisition route, for many companies the cost
of going public is too high, and when faced with a cheaper,
less risky alternative the acquisition wins. Unfortunately,
consolidation acquisitions is much less conductive or conducive
to job and technology growth.
The second strategy is companies choosing to go public on
foreign exchanges. In 2005, there were 519 IPOs on the London
AIM. In the first quarter of 2006 we saw for the first time two
of 12 U.S. venture-backed companies went public on the AIM, and
decided not to use the NASDAQ.
Eighteen months ago, if you queried a room of ventured
capitalists about the London AIM, few would have had the market
on their radar screen, I think today it's viewed as a viable
and better understood option for many of VC-backed companies.
While specific provisions of the original Sarbanes Oxley
law have improved certain practices at U.S. companies, Section
404 has done little in the way of advancing fraud. We have
witnessed the information compiled from a 404 audit to be
unwieldy, out of date, and of little or no use to investors.
I'm not aware of any evidence that Section 404 has been a
critical factor in uncovering fraud, such malfeasance is almost
always discovered by new employees or auditors joining a firm,
rather than from compiling documents.
As a committed investor in small and emerging growth
companies, I strongly support the recommendation of the SEC
Advisory Board on the smaller public companies, the
recommendation for tiered regulations. Size appropriate
structure already exists in other regulations, and I would
argue that intelligent small company investors would easily
exchange a certificate of compliance for the extra million
dollars in that income that would come from tiered regulatory
relief.
Further, I am very supportive of any provision that will
help stimulate more competition in the accounting profession.
Our supply of qualified accountants to do work for small
companies is not meeting the increased SOX demands. We would
welcome new entrants wholeheartedly.
Companies that seek to thrive and create value will always
comply with the highest standards. It's critical for market
credibility, but the time has come to set the bar accordingly,
and reduce the unnecessary frictional costs of SOX 404, in the
best interest of growing companies and growing economy.
Thank you for the opportunity to weigh in on this vital
matter.
[Mr. Crandell's testimony may be found in the appendix.]
Chairman Manzullo. Thank you.
Our next witness, I read the press release you put out last
night.
Mr. Neiss. You liked it?
Chairman Manzullo. It was good.
Mr. Neiss. Right.
Chairman Manzullo. Yes, you know, if this meeting had been
cancelled I don't know what you would have done, you know.
Mr. Neiss. I'd still be here.
Chairman Manzullo. I appreciate that, it shows your
enthusiasm for being here, and, Woodie, is it Neiss?
Mr. Neiss. Neiss, yes.
Chairman Manzullo. Woodie Neiss is the Co-Founder and Chief
Financial Officer of FLAVORx, Inc., a company that puts
flavoring into medicines. We look forward to your testimony.
STATEMENT OF WOODIE NEISS, FLAVORx, INC.
Mr. Neiss. Thank you very much.
Chairman Manzullo, Ranking Member Vel zquez, and Members of
the Committee, thank you for inviting me here today. My name is
Woodie Neiss, and I represent what is great about this country,
the ability to take an idea and turn it into a reality.
I'm an entrepreneur and a Co-Founder of the company
FLAVORx. We are an INC500 high growth, young energetic small
business, helping millions of sick children get better faster
by being more compliant with their medicines. We believe we are
saving the U.S. healthcare system over $100 million a year in
unnecessary medicines, doctor visits, insurance claims, gas,
time and resources of parents, and the companies they work for.
I represent a different generation of business owners than
those of Enron and WorldCom. We respect the rules and morals,
and believe you can run a business fairly. I believe that
FLAVORx has what America needs in the form of a public company.
Over the past several years, we have had steady growth,
maintained positive cash flow, and consistently grown our
bottom line. I often get calls from parents asking if we are
publicly traded. It's for this reason that we've been able to
attract capital from friends, family and most recently private
equity, with the hopes of going public.
Wanting to do it right, we've diligently grown our business
by implementing ethical business practices along the way. This
wasn't a product of legislation, that's just what you do to
grow a business and raise capital.
Part of our process always includes an audit of our
financial statements. We feel it is necessary to have an
independent auditor review our books to verify their accuracy.
It not only reassures us that what we are doing is right, but
provides a vote of confidence to our business partners.
Over time, we've grown our audit relationships, and in 2002
in anticipation of an IPO we hired Ernst & Young. What we
didn't realize we faced though were adversarial, theoretical
debates over revenue recognition procedures, concentration on
overly detailed reporting systems, time consuming discussions
over policies and procedures irrelevant to a company of our
size, and extra costs in the form of consultants and legal
fees.
Our $10,000 a year, two-week audit suddenly jumped to a
$70,000 four month audit. On top of that, these fees
represented a substantial 14 percent of our net income. There's
a fundamental difference between a small company with public
aspirations like ours, and a multi-billion dollar company. We
do have the deep pockets, unlimited personnel, intricate
infrastructure, or complexity they do, and hence don't need the
same resources or structure to explain our simple actions.
Trying to dig for problems in a company like ours, where
problems don't exist, is counter productive. Spending money to
uncover these problems, when I can use it to invest in sales
and marketing, seems a waste. To hold us accountable to rules
where the challenges are different or non-existent are an
unintended result of this legislation that is lining the
pockets of auditors, consultants and lawyers.
It was for this reason last year that we decided to drop
our relationship with E&Y. We also started to second guess our
desire to go public. I mean, why go public when Sarbanes Oxley
audits are so expensive and painful? Why put yourself through
the agony, when in the end there's nothing to uncover?
When it comes time to audit season, you are guilty until
proven innocent. It doesn't sound very American, does it?
I highly doubt FLAVORx is unique when I say we want our
investors to know the good and the bad, that transparency is a
part of our lives. However, we, like many small businesses, are
not complex. Unfortunately, however, Sarbanes Oxley does not
take this into consideration. There needs to be some middle
ground. There should be a threshold based on the complexity of
an organization determined by its revenue to which companies
should be held accountable to SOX. Until then, we can use these
funds to better grow our companies, rather than reduce our net
income.
Of course, the option always exists that we can pass these
costs off to the consumers, but I highly doubt this was the
intention of Congress. We, as business leaders, can change-can
behave ethically without being forced by legislation. To lose
confidence in us is to lose confidence in the majority of the
good companies out there that are trying to succeed in this
challenging business environment of higher costs and increased
competition.
Public markets allow companies like FLAVORx access to
capital which enables us to grow much faster, hire more people,
and consume more American products. This grows our economy more
than if we were just to sell to a larger company. However,
public markets at the expense of Sarbanes Oxley do not make for
attractive options.
I know this Committee represents the interests of small
businesses, and I hope you can help influence your colleagues
to understand the repercussions that Section 404 is having on
us.
Thank you again, Mr. Chairman, for holding this hearing and
allowing me to testify. I look forward to your questions and
our discussion.
[Mr. Neiss' testimony may be found in the appendix.]
Chairman Manzullo. Appreciate that. I'm just wondering when
people call your company and are put on hold, if that song, ``A
Spoonful of Sugar,'' is there.
Mr. Neiss. We tried, but Disney got-we got in trouble with
Disney.
Chairman Manzullo. You did say that you are law abiding,
that's great.
Our next witness is Mark Schroeder, with the Independent
Community Bankers of America. He's President and Chief
Executive Officer of German American Bancorp in Jasper. How
many people live in Jasper?
Mr. Schroeder. About 15,000.
Chairman Manzullo. Oh, that's a big city.
We look forward to your testimony.
STATEMENT OF MARK SCHROEDER, GERMAN AMERICAN BANCORP
Mr. Schroeder. Thank you.
Thank you for the opportunity to testify today, good
afternoon. My name is Mark Schroeder, and as the Chairman said
I am President and Chief Executive Officer of German American
bancorp. We are located in Jasper, Indiana, and we are a
community bank holding company, with approximately $1 billion
in assets.
It is my pleasure to speak today on behalf of both my
company and the Independent Community Bankers of America, which
represents approximately 5,000 community banks in the United
States, many of whom are publicly held, and speak on the costs
of Section 404 of Sarbanes Oxley, and on the recommendations
included in the final report of the SEC Advisory Committee on
Smaller Public Companies.
Let me give you a little background on German American.
German American bancorp was formed in 1983, and we were formed
with the express purpose of providing a vehicle for small
community banks to come together to achieve economies of scale
and to obtain the liquidity of a publicly-held community
banking company.
Since 1983, nine community banks, the majority of which
have served their communities in southern Indiana for over a
century, have joined our company, allowing their shareholders
the opportunity to continue holding an investment in their
locally-owned community bank.
German American is listed on NASDAQ. We have approximately
3,500 registered shareholders, and we have a market
capitalization of $144 million.
I think I bring a unique perspective among the witnesses
today, because German American bancorp is an accelerated filer
with the SEC, and we have, therefore, been subject to SOX 404
compliance for the last two years.
For 2004, our direct costs as a company, just for SOX 404
compliance, amounted to nearly $600,000, with an additional
estimated $250,000 of internal indirect costs, for total
compliance costs of $850,000, which equates to .08 cents per
share for our shareholders.
For 2005, our costs declined, but even these declined
costs, the direct costs were $350,000, and our indirect costs
were $150,000, for a total cost of $500,000, or approximately
.05 cents a share.
Now, these costs are extremely high, but these costs fail
to consider and take into account the internal operating
inefficiencies that have been created because of the
duplicative internal controls that we have had to put in place
since the implementation of 404.
In an effort to be conservative, and to avoid being
questioned by the PCAOB, accounting firms, ours included, are
requiring layer, upon layer, of checks and balances, beyond
that which can be justified on any kind of risk cost basis
beyond that needed for proper segregation of duties, and beyond
anything that's ever been required by the banking regulators.
In particular, the cost of duplicate checks and balances,
coupled with the requirement for layer, upon layer of
documentation of these duplicative processes, have added
additional operating inefficiencies through every area of our
company.
The cost of this inefficiency is impossible to measure, but
it is significant, and at a minimum we believe it is equal to
or in excess of the measurable indirect costs.
For many publicly-held community banks and holding
companies, the immediate response to the high costs of SOX has
been to go private, and cease being registered as SEC filers.
Since the beginning of 2003, 75, over 75 community banks have
filed to go private. The reasons cited in these filings
uniformly include increased legal and auditing hard costs, and
management staff time soft costs, associated with the Exchange
Act, but unquestionably 404 compliance is the biggest concern.
Unless something is done to ease the burden of 404, we
would predict that as the micro cap companies, those below $75
million of market cap, are looking at facing this, you will see
a flood of public banks, small public banks, choosing to go
private.
The SEC Advisory Committee on Smaller Public Companies
should be commended for its fine work in preparing and drafting
the final report, and including more than 30 recommendations
for scaled or proportional securities regulation for smaller
public companies. Among the Advisory Committee's primary
recommendations, ICBA strongly endorses exempting micro caps
from the internal control attestation requirements of Section
404, and unless and until a framework for assessing internal
controls over financial reporting for such companies is put in
place for the small cap companies, exempting those small cap
companies from the external audit requirements of 404.
We agree strongly with the Advisory Committee that with
more limited resources, fewer internal personnel, and less
revenue with which to offset the costs of 404 compliance, both
micro cap and small cap companies have been disproportionately
impacted by the burdens of Section 404 compliance.
We also agree that the benefits of documenting, testing,
certifying the adequacies of internal controls, while of
obvious importance to large companies are of less value for
micro cap and small cap companies who rely to a greater degree
on tone at the top and high-level monitoring controls to
influence accurate financial reporting.
There has been little attempt by either the SEC-
Chairman Manzullo. How are you doing on time there?
Mr. Schroeder. -okay, I'll wrap up here, Chairman.
There has been little attempt by either the SEC or the
PCAOB to tailor or scale regulations to address the
disproportionate costs and burdens.
On behalf of the nearly 5,000 members of the Independent
Community Bankers of America, we urge the members of the
Committee on Small Business to support the Advisory Committee's
recommendations, and urge the Securities Exchange Commission to
adopt them.
Thank you.
[Mr. Schroeder's testimony may be found in the appendix.]
Chairman Manzullo. Thank you.
Our next witness is James Burns. Mr. Burns is President and
CEO of EntreMed, Inc., speaking on his behalf, and also on
behalf of his trade organization, the Biotech Industry
Organization or BIO. We look forward to your testimony.
STATEMENT OF JAMES BURNS, ENTREMED, INC.
Mr. Burns. Thank you, Mr. Chairman.
Chairman Manzullo. Could you pull the mike a little bit
closer, sir?
Mr. Burns. Sure.
Thank you, Mr. Chairman, Ranking Member Vel zquez, and
Members of the Committee. As a native Illinoisan I'm glad to be
here, and also to be here to talk about the issues involved in
Sarbanes Oxley Section 404.
I am the President and CEO of EntreMed, a public
biotechnology company in Maryland. I have been involved in
leading the development of biotechnology companies and products
for over 20 years. Founded in 1991, EntreMed is a clinical
stage pharmaceutical company, focusing on the development of
next generation anti-cancer and anti-inflammatory drugs that
target disease cells directly in the blood vessels that nourish
them. Our focus is on the development of drugs that are safe
and convenient, providing the potential for improved patient
outcomes.
Our company currently has three drug candidates in clinical
trials for cancer, as well as others in pre-clinical
development for oncology and non-oncology indications. Our
company has no product sales, and will depend on continued
investment capital for the foreseeable future to maintain our
clinical development programs.
I'm here today to testify on behalf of the Biotechnology
Industry Organization or Bio, an organization representing more
than 1,100 biotechnology companies, academic institutions,
state biotechnology centers, and related organizations in 50
states and 31 nations. Our members are involved in the research
and development of health care, agricultural, industrial and
environmental biotechnology products. The majority of our
member companies are small research and development oriented
companies, pursuing innovations that have the potential to
improve human health, expand our food supply, and provide new
sources of energy.
My company has a profile that is typical of the high risk
capital-intensive, long lead time regulated business
environment of the biotech industry. As a representative of one
of the most innovative high growth sectors of our Nation's
economy, one in which the United States maintains a global
leadership position, my testimony is tailored to the issues
faced currently or that will be faced by emerging companies in
the biotech sector, the micro cap and small cap companies who
are among the driving forces of our country's innovative
leadership and competitiveness in global marketplace.
Let me, basically, say we appreciate and agree with the
congressional intent behind 404, ensuring that companies will
have the effective policies, procedures and controls to protect
against material mis-statements end product and protect it
against fraud. Where Section 404 has gone awry, however, is in
the implementation.
The reason for increase cost burden is the imposition of an
inflexible Section 404, and companies with fewer personnel,
little or no revenues, and minimal resources. Simply put, if
the current 404 implementation continues to be imposed, micro
cap and small cap companies in our industries will be forced to
endure internal processes and organizational changes that are
completely contrary to the rapidly changing and highly
competitive markets in which we operate.
Let me put 404 into real company context by providing some
examples, if you would. One of BIO's member companies has five
employees working on Section 404 compliance, at a cost of
approximately $1 million per year. This company estimated that
its Controller spent approximately 35 percent of his time on
404, while the CFO spent approximately 20 percent of the time,
to complete the mandated internal control processes and the
checklists dictated by AS2 the company had to increase its
accounting staff by 40 percent.
Another member's experience shows the impact of 404 with
respect to opportunity cost. This company not only spent
approximately $500,000 on its external attestation of internal
controls, but also had to endure additional costs in terms of
(1) the reassignment of laboratory research personnel to
perform internal control work dictated by AS2; (2) the
postponement of hiring of five or more additional researchers,
the delay of promising R&D programs.
Other issues that this company was trying to deal with was
whether they would have had to file additional patents. There's
100 patents in this company right now, and whether and where to
file additional patents.
This company could also purchase an entire amount of active
pharmaceutical ingredient for one of its clinical product
candidates for the same cost associated with complying with SOX
404. To say the least, this is clearly an unintended and
unfortunate consequence of Section 404.
The risks in our business are patient safety, FDA
compliance, and the uncertainty of research outcomes. SOX 404
does not reduce these risks.
For investors, their confidence and trust in public
companies may have increased as a result of the passage of SOX
as whole, in spite of Section 404, not necessarily because of
it.
We view CEO and CFO certification under Section 302 as
beneficial and a requirement that we are not contesting. As we
saw in the first and second years of 404 implementation,
investors were less concerned when a company reported a
material weakness in internal controls than how much a small
company was paying to meet Section 404 requirements for much
more complicated businesses.
Chairman Manzullo. How are you doing on time?
Mr. Burns. I'm just going to wrap up shortly.
Chairman Manzullo. Okay.
Mr. Burns. Biotechnology start-up companies early in their
histories often have very limited or no product revenues
compared to their market capitalization. So, for these reasons
BIO has urged the Securities and Exchange Commission to-and the
Public Accounting Oversight Board, as expeditiously as
possible, to take the necessary steps to adopt a reform
framework recommended by the Advisory Committee's final
recommendations.
That concludes my testimony. Thank you.
[Mr. Burns' testimony may be found in the appendix.]
Chairman Manzullo. Okay, Mrs. Kelly.
Mrs. Kelly. Thank you.
I apologize, I have a very busy schedule and I have to
leave.
As one of the people who helped to write SOX, and helped to
write Section 404, you have to put that into context of what
was happening at the time that we wrote it. It was certainly
not intended by Congress to put a chill factor on businesses.
And, I am concerned, I think we do need to take a look at it.
With that in mind, I'd like to talk to you, Mr. Wander,
about a question I had, rather than divide companies by market
capitalization, would it have made more of an impact to look at
companies that need relief from the cost of compliance in terms
of take a look at small businesses that nearly have their
profits erased by the cost of the compliance, looking at it
that way rather than-in other words, the percentage that it's
costing them out of their bottom line. And, is there some
reason why you didn't do that?
Mr. Wander. Yes, one of our mantras was to keep it simple.
We think that one of the just general problems, in terms of
both legislation and regulation, is that things get so
complicated that it's very difficult to comply with it, it
takes away the use of professional judgment.
So, we tried to figure out all sorts of metrics that would
apply to scaling the regulation for public companies.
Most of the people that commented felt that market cap was
best. The second was, essentially, frankly, number of employees
or revenue, and we discarded that. And, we considered scaling
based on what your profitability was, but again, most of the
comments we had felt that that would be no good because, you
know, very large companies went into bankruptcy who still, for
example, had no income whatsoever and needed-were large
organizations, United Airlines being one of those, that still
needed to have a robust internal controls over financial
reporting.
Mrs. Kelly. Mr. Wander, did you look at the idea that you
could maybe look at the mandates relative to the percent of
resources that a company needs to devote to compliance, rather
than their profitability or numbers of employees and all of
that that you just mentioned, did you look at what it cost the
company for compliance and think about a sliding scale of
percentages in terms of applying 404?
Mr. Wander. We didn't look exactly at that level. We are
out of business, so I can't say we'll go back and look at that,
but it sort of gets difficult in my first reaction to sort of
figure out, well, if I have revenues of, let's say, $50
million, and I want to spend up to half a million dollars, 1
percent of that, how do you cut that off?
And, the accounting firms were very adamantly against
establishing a standard where you would say, okay, for a $50
million company you would have to do a $500,000 internal audit.
On that issue, we ran into, frankly, a total road block by
the accounting firms.
Mrs. Kelly. I can understand that, if you have-with a
$500,000 audit, however, we do know, and you know because you
reported the cost of audits is going down, we have to remember
that this was put in place to protect the American investor,
and while I am absolutely concerned about small and mid cap
companies and their compliance, this was not meant to be a
chill factor on business in the United States. But, we still
need to have transparency so that people understand what that
investment is going to be.
Part of the thing that concerns me in transparency, also
with regard to small and mid cap companies, concerns naked
short selling, which I was hoping that we-I brought up in a
hearing this morning, because that is affecting our small and
mid cap companies, and I was kind of hoping that maybe you all
might have taken a look at that at the same time that you were
doing this.
Mr. Wander. It was one of the items on our agenda, and,
frankly, we concluded that we are a limited life group with
some sort of resource constraints, time restraints, and while I
agree with you wholeheartedly that that's a very important
aspect, it wasn't-we just didn't put it as high on our agenda,
because we frankly think the SEC and NASDAQ are addressing that
issue.
Mrs. Kelly. I have just one other comment, this to Mr.
Crandell.
Mr. Crandell, you were talking about, you represent the
venture capitalists, I'm quite concerned that we in government
are putting grants out to help people develop ideas and bring
everything up to a certain point, where at the point where they
are needing to go from a granted position into production, into
a prototype model of what they are doing, there's an area that
is talked about in the agencies of government called the
``valley of death,'' because the venture capitalists, you can't
blame them, won't go in.
It would be very good if we could somehow develop a way to
bridge that gap. It may be a public/private partnership or
something, because I've been working on that for ten years, and
I can't seem to figure out how we can force the agencies of
government to bridge that gap, so that the venture caps can
come in. I can't blame them, they are out there on the edge of
the risk anyway.
Maybe you wouldn't mind engaging in a dialogue. I don't
know if you want to talk about it now, but certainly you can
find me and I'd be interested in talking with you, maybe we can
bridge a gap to help our companies make that jump, so they
become viable and help us grow the economy.
Mr. Crandell. Yes, Congressman Kelly, I'd welcome the
opportunity, and I'm happy to do that off line.
I would say that there are groups of venture capitalists
that do seed and early-stage investing. We have done 115
companies in the last 20 years. We've co-founded most of those
with technologists, scientists and, you know, I think it's a
really important area to make sure that the U.S. is very
efficient and taking inventions and turning them into business'
revenue that employ people. So, I'm happy to talk about it.
Mrs. Kelly. Thank you.
Mr. Crandell. Sure.
Chairman Manzullo. I recognize the Ranking Member for her
questions and comments.
Ms. Vel zquez. Thank you, Mr. Chairman.
Mr. Wander, let's get right to one of the biggest issues
facing the Advisory Committee's reform proposal. Critics
suggest that if the Advisory Committee's primary
recommendations regarding internal controls are adopted that
investor protections will be undermined. What investor
protection requirements would still apply to small companies
that are afforded relief under the Advisory Committee's
recommendations?
Mr. Wander. Yes, thank you.
First, all of the companies, whether they be micro caps or
small companies, would be required to have internal controls
over financial reportings. That's been mandated since 1997.
They will still be in existence and applicable to all these
companies.
Secondly, these companies will have to provide the
certifications that are required under Section 302 of Sarbanes
Oxley by the Chief Executive Officer and the Chief Financial
Officer, attesting to the compliance with both financial
disclosures and other disclosures in their narrative portion of
their documents. So, those two people will be on the line, and
I can tell you from my own experience as a lawyer representing
many of these companies, the executives take that role very
seriously. It is not something that's sort of a throw away and
they sign it.
Third, they will all go through their regular audits, and
we have learned, and this is unchallenged by anybody, that for
the micro cap companies the regular audit is really the audit
that catches errors and fraud. You don't need a separate
external audit for those companies. So, that would still be in
place.
Ms. Vel zquez. So, you agree that investors will still be
sufficiently protected?
Mr. Wander. Yes, I believe they will.
Ms. Vel zquez. Mr. Burns, we have heard that what drives
investment in the high-growth setup, biotech and hi-tech
sectors, is proof of concept, not Section 404, and that some
companies are spending the equivalent of six months of R&D
funding to cover the costs associated with Section 404.
Based on your experience, how much of an impact does
Section 404, as currently implemented, have on increasing
investors confidence?
Mr. Burns. Investor confidence is primarily driven by
progress to proof of concept. Money goes into, typically,
companies like ours and it's expensed, it's expensed internally
and externally, and the progress that's made on R&D, the
progress that is made in clinical trials, the compliance with
safety requirements of the FDA and so on are the things that
investors particularly pay attention to, whether or not their
investments in the company are being spent efficiently on R&D
and efficiently on clinical trials, and whether the company is
making progress toward ultimately getting approval.
And, they expect that when an audit is completed, and the
CEO and the CFO certify to the financial, the accuracy of the
financial statements, that that is what they are certifying to.
Ms. Vel zquez. Thank you.
Mr. Wander, last week, and I sit on the Financial Services
Committee, Marsh Carter, Chairman of the Board of the New York
Stock Exchange group, testified before the House Financial
Services Committee on maintaining the international
competitiveness of the U.S. financial markets.
In order to keep U.S. markets competitive Mr. Carter
proposed that the SEC and PCAOB move to a three-year Sarbanes
Oxley Section 404 review cycle, as a way to reduce regulatory
burdens. He noted that this could be accomplished without
having to pass legislation to amend the law.
Do you think this proposal will help small companies by
reducing the cost of compliance?
Mr. Wander. We considered that very seriously in our
deliberations, and concluded, again, we ran into actually
opposition from both the issuers and the accounting firms, and
their arguments were that once you get subject to 404 it's a
shock, and having it every three years would be worse than
having it every year. It's like going into an ice cold water.
And, we thought, and still think, that the better approach
is to scale the regulations for smaller public companies, so
that they still have to go through rigorous internal control
establishment and examination, but that it should be scaled to
the size of the company, and it should be every year.
So, but I don't throw out the three-year requirement off
hand. We did look at it, and thought ours was better.
Ms. Vel zquez. Thank you.
My next question is to you, Audit Standard No. 2 implements
Section 404, AS2, as it is known, is long on guidance for
accountants, but short on guidance for small companies. COSO
has attempted to fill this void and provide additional guidance
for small companies. What is your opinion of COSO guidance in
this area?
Mr. Wander. It's still deficient, and they came out, they
worked very hard to produce some guidance at the request of the
SEC, and I believe the PCAOB. The exposure draft came out, oh,
three, four, five months ago. Comments were almost uniformly
negative. It was a 200 and some page guide, and the problem was
the guide, by the time you read it you were more confused than
when you started.
And, it's unfortunate, because I value COSO and the people
who work there who are, I think, truly trying to find a
solution. They are now revising it, I don't know what the
revision will be, but I think in general it was just too long
and not pointed enough.
Ms. Vel zquez. My time is up.
Mr. Bartlett. Thank you very much.
I have here a copy of a letter from the Office of Advocacy
of the Small Business Administration to the Honorable
Christopher Cox, with whom I had the privilege of serving in
the House. And, Roman Numeral I says, ``SEC should not impose
disproportionate burdens on smaller companies by excluding them
from access to capital markets.''
I'd first like to apologize for not being here for your
testimony. I'm also on the Armed Services Committee, and this
is that one day in the year when we have a mark-up. Ordinarily,
it lasts til midnight. I think that in the next hour or so it
will be over, it's going very well today, and so I couldn't be
here for your testimony.I gather that compliance with these
regulations is imposing a burden on small business. I would
like to ask a couple of questions. First of all, is it your
view that when they wrote these regulations, as a result of our
law, that they had small business at the table, that they went
through the requisite hearings, and hearing from small business
how the implementation of this that might be acceptable to
large business would be an inappropriate burden on small
business, do you think that they went through that required
procedure? Any or all of you.
Mr. Wander. Well, I will start the answer. I'm sure my
colleagues here can fill in.
We think that's one of the very serious problems, is that
the smaller and mid cap public companies are literally orphans
in this process. The original COSO recommendations of the early
`90s had very small chapters in the massive two volume set of
guidelines dealing with small businesses. And, it sort of said
they are very different, and you have to scale the regulations
in order to have smaller companies comply on a reasonable and
efficient basis.
When AS2 was first promulgated, the PCAOB, in fact, did
have an appendix dealing with smaller public companies, which
was taken out when the final rules were adopted.
And so, one of the points made by the Advisory Committee is
that no one has really taken the time or effort to focus on
what the standards should be for smaller and mid cap companies.
Mr. Bartlett. Anyone else wish to respond?
I'm going to violate some rules probably, but they have a
vote and it's just a couple of floors away. I'll be back very
quickly, but they are having a roll call vote in Armed Services
and I'm needed there. I'm going to do what you should never do
and turn this over to a Minority member.
Ms. Vel zquez. Well, continue practicing it.
Mr. Wander, let me continue to ask some questions here.
Given the effect of Sarbanes Oxley on the public accounting
industry, there was speculation that some smaller CPA firms
will drop their public clients.
There was concern that this would lead to fewer companies
in an industry already marked by significant consolidation.
While the General Accounting Office addressed this issue in a
study two years ago, could you please provide your perspective
on what role smaller CPA firms are playing in the market for
Sarbanes Oxley audit services?
Mr. Wander. I believe that particularly the next five in
size firms who are actually very active with our Advisory
Committee, and many of the regional accounting firms, need the
strong support from the SEC, the PCAOB and Congress. They are
very talented people. It probably has some limitations, they
aren't as global as the Big Four, but they certainly are very
fine professionals for businesses that are, essentially,
located here in the United States.
And, I think you will see a trend, I don't think it's fast
enough, where many smaller public companies will go to the
smaller accounting firms. I think one of the witnesses talked
about the fact that unfortunately underwriters and banks
sometimes insist on a Big Four. In fact, Chairman Cox I think
has spoken out in saying people should look at smaller
accounting firms, and I think that that will be one way,
hopefully, we will have a much more vibrant accounting
profession, with more opportunities and choices for all
businesses.
Ms. Vel zquez. Thank you.
Mr. Schroeder, how have the compliance costs associated
with Section 404 affected your bank's ability to invest in the
local community?
Mr. Schroeder. Obviously, when you have a cost of a company
of our size that in the first year was approaching a million
dollars and now has kind of settled it at a half million
dollars a year, it impacts our ability to invest in the local
businesses that we do business with and the local companies, as
well as the local individuals. From a Community Reinvestment
Act perspective, it's probably a good place to look at it.
When we are looking to make an investment from community
reinvestment, that half million dollars that we are spending on
404 could be allocated towards CAR type investments, but it
can't go both places. A half million dollars a year for our
company is a significant additional cost that will come out
somewhere in the mix.
Ms. Vel zquez. Thank you.
Mr. Wander, none of the top ten initial public offerings
last year were registered in the U.S., and 23 of the 25 largest
IPOs occurred in foreign markets. Anecdotal evidence suggests
that the high costs associated with Section 404 are helping
drive this trend and causing U.S. companies to raise capital in
foreign exchanges, such as the London Exchange Alternative
Investment Market, and some of the witnesses raised this issue,
too.
To what extent has the burden associated with the Sarbanes
Oxley Act deterred private companies from going public in the
U.S., and to instead list on foreign exchanges, such as AIM?
Mr. Wander. I think that's a growing phenomenon that you
will see more and more of. AIM is coming to the United States,
they almost have full-time representatives.
And, I would add with that the Toronto Stock Exchange,
which is really the TSX, which also tries to capture smaller
businesses with a model somewhat similar to the AIM market.
They, in fact, presented a program at the Business Law Section
of the American Bar Association meeting last month in Tampa,
all foreigners gave the presentation, and they are going around
to various cities in the United States trying to get listings.
And, I don't think there's any question that they will gain
many more companies to go into their system, because for a
small public company to take so much of their revenue or their
cash resources to comply with Sarbanes Oxley, particularly,
404, especially 404, that they will continue to move to foreign
markets.
And, I think Sarbanes Oxley is one of the big factors. I
think as a New York Stock Exchange representative testified,
litigation is another one.
Ms. Vel zquez. But, do you believe that the Advisory
Committee's recommendation will help reverse this trend?
Mr. Wander. Yes, ma'am.
Ms. Vel zquez. Okay.
Mr. Broderick, if the Advisory Committee's recommendations
are enacted, would you consider your decision to not go public?
Mr. Broderick. If they were enacted to have a scaling
proportional regulation, yes, we would then, right now,
Congresswoman, the way we look at it is, an IPO is not feasible
right now, but we say into the foreseeable future for a
technology company that's, you know, three years at best, but
we look at that we need to get to a certain level of critical
mass in order to absorb the SOX compliance issues.
For us, that would be, we are a $50 million company right
now, the way we look at it we roughly would have to get to $150
million to give us enough market capitalization, roughly about
a half a billion dollars or so, to absorb that cost.
I would say, Congresswoman, just small cap companies,
especially micro cap companies, in order to get liquidity in
their stock, and institutional investors and other investors
awareness to buy their stock, the time commitment and resources
that the CEO and CFO to put at that is tremendous. When you add
SOX on top of that, we looked at it and we just, it was a no
brainer, we said we can't go public because we'll put our
shareholder value more at risk. For a small cap public company,
you put estimates out there. We are not like Google, we don't
have to give guidance. If you don't give some kind of guidance,
no one will follow you, no one will be interested in your
stock.
So, you are out doing your own marketing efforts to get
that interest, and that's just the general dynamics and the
burdens on executive management to create liquidity in the
stock. If you miss an estimate, a quarterly estimate, you know,
by a penny, your stock can drop 50 percent easily.
So, when we look at it, the risk of that was so great, and
the diversion of time and management towards SOX compliance,
that we said we have a chance to lose 70 percent of our value,
we might as well just stay private, build the company, and move
forward with our strategies.
Ms. Vel zquez. Thank you.
Thank you, Mr. Chairman.
Mr. Bartlett. Thank you.
I'm privileged to serve on three of the least partisan
committees in the Congress. This is certainly one of them. I
don't know of anybody here who isn't a small business
supporter. I serve on Armed Services, and I serve on Science,
so I had little fear that turning the Chair over to the
Minority would be abused.
In another life, I was in business, as a small business
person, and I learned very quickly that regulations that were
acceptable to large businesses, if you have 300 people and it
takes three people to comply with the regulations, that's a
burden, but not a burden you cannot bear. If you have four
employees and it takes three to comply with the regulations,
that's clearly a burden that you can't bear. And so, you need
to be careful whose business advice you are getting, because
the strongest competitors for big business is frequently small
business, and regulations are a way of neutralizing, neutering
in many cases, a small business. You need to be careful who you
are asking about whether these are acceptable regulations or
not, because they may be acceptable to big business because
it's a burden they can easily bear as a part of their overhead,
and, furthermore, it now puts their small business competitors
at a disadvantage. I see a number of you nodding your heads in
assent, so you've been there and you understand this.
It's quite clear from your testimony that compliance with
the regulations resulting from this law is imposing an undue
burden on small business. The question I need answered is, is
there a regulatory fix for this, or do we need to have a
legislative fix for it? Is this something that we can hold the
bureaucrats responsible for? Can they, within our law,
promulgate regulations that will be effective and yet
consistent with the view that small businesses should not be
unduly disadvantaged by these laws? Can the regulators fix it,
or do we have to legislatively fix it?
Mr. Broderick. Congressman, I think if the SEC adopts the
scaling proportion, it's just common sense, I don't see any
reason why they wouldn't adopt this and move forward with a
framework, and then they can tweak that framework as they see
fit.
To me, if they don't anything, if they just bury their
heads in the sand about it, you are going to have small
companies just, you know, not being able to attract any
capital, even VC capital. Early-stage companies are going to be
knocked out of the marketplace, because they see too much risk.
Now, a VC comes in and he puts a certain level of
infrastructure into a company, an early-stage company, and
that's, you know, basic accounting, finance, HR type of
infrastructure, but now you've got to take that extra layer on
top of that, and based upon the risk models of VC firms they
don't know if they are ever going to get to a public
marketplace.
So, if those resources are diverted, you are not properly
growing your company to get adoption of technology products and
services in the marketplaces that you serve.
So, as far as - I believe it was a very, very good study
and report, taking something and boiling it down, as complex as
it is, and simplifying it, I think it was-I commend the
Advisory Committee, I think they did a heck of a job with it,
and I don't-it's just common sense, and we need more common
sense.
Mr. Bartlett. Is it your general view that if the
recommendations of the Advisory Committee were implemented that
it would largely fix the problem?
Mr. Schroeder. Speaking as a company that has been an
accelerated follower, and has been through 404, absolutely. For
German American bancorp, and for many of the community banks,
public community banks, that ICBA represents, those
recommendations would absolutely fix the problem for us, or a
significant portion of it.
The portion that we would be left with are good controls,
they are controls we can live with, they bring value to our
investors, but it is the 404 compliance and this piling on of
layers and layers of bureaucracy that it would fix.
So, for us, absolutely, it would fix it.
Mr. Bartlett. Yes, sir.
Mr. Burns. Mr. Chairman, I believe that it would certainly
help my company, and it would more than likely help most of the
other companies that are biotechnology companies, and rely on
the capital to grow their companies.
And, it's also my understanding that the Commission has the
authority to implement the recommendations and we fully support
that. The sooner the better, sir.
Mr. Bartlett. Do you believe that the recommendations they
made are consistent with law? Was there any ever discussion,
any discussion that we might need new legislation to permit
them to do what seems so reasonable to you?
Mr. Wander. Perhaps I should at least try to answer that
question.
One of our goals, it wasn't in our mission statement, but
one of our goals since we were an advisory committee to the
Securities and Exchange Commission, was that we wanted the
Securities and Exchange Commission to implement our
recommendations. So, we believe wholeheartedly that the SEC
does have authority under the various securities laws to
implement our recommendations.
I should be totally frank with you, there are people who
question that, because of a quirk, Section 404 is not part of
the Securities Exchange Act of 1934, where the SEC has some
broader authority to adopt regulations. But, we make a case for
this in our report, and I believe that Congressmen Oxley and
Baker have, in fact, written to the SEC a letter indicating
that they believe wholeheartedly that the SEC does have the
authority to adopt our recommendations.
On the other hand, Senator Sarbanes is probably on the
other side on that question.
Mr. Bartlett. Yes, so often what you see depends on where
you sit, doesn't it?
Mr. Wander. Yes.
Mr. Bartlett. These two people are kind of the extremes of
the political spectrum, and they are looking at the same law
and come to different conclusions.
But, it's my understanding that Chairman Cox would be
responsible for implementation of this.
Mr. Wander. He, together with the rest of the
Commissioners, yes, sir.
Mr. Bartlett. Is it your understanding that this has come
to his attention?
Mr. Wander. Oh, yes, he has commended our report, and said
that it would be studied quite thoroughly, which I'm sure it
will. The SEC is a very responsible agency.
We, as someone just said, hope that they do it on a rapid
pace, and that they do adopt most of our recommendations, if
not all of them, but we will see how that pans out. It's only
been a week since they've gotten the report, although I think
they knew it was coming and what the recommendations have been
for probably two to three months.
Mr. Bartlett. These regulations were promulgated before
Chairman Cox took over?
Mr. Wander. Yes.
Mr. Bartlett. So, this is not his child?
Mr. Wander. That's correct.
Mr. Bartlett. Okay.
I want to ask my Ranking Member if she has any additional
questions or comments?
Ms. Vel zquez. No, I don't.
Thank you, Mr. Chairman.
Mr. Bartlett. Okay.
Well, I want to thank you all very much for the
contribution that you've made. We will wait a reasonable time
to see if SEC responds responsively. If they do not, why I
suspect that they will be sitting in your chairs telling us why
they have not.
I know Chris Cox very well. He's a genuinely thoughtful
good guy, and if he doesn't respond promptly it will be because
there's just a lot of other things on his plate which have kind
of pushed this aside. We'll make sure that that doesn't happen
for very long.
You are in a better position to judge than we as to how
soon they ought to have responded to this. We would like your
commitment to get back to us when you think they should have
responded and they have not, and then we will follow through on
it.
I want to thank you all very much for your testimony, and
our Committee is adjourned.
[Whereupon, at 4:13 p.m., the Committee was adjourned.]
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